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Can you guess what they said?
No, it wasn’t more coverage of Apple or Tesla, those are already well covered by the likes of CNBC, sell side firms and blogs.
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This answer makes sense: we all want to collect more winners in our portfolio.
But after following investments of ultra-famous investors (Buffett, Dalio, Icahn), reading diligently through 10-Qs at night, and even combing through article after article on obscure forums and blogs, it can be hard to find qualified “special situation” ideas that aren’t already widely known.
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Below is an excerpt from our interview with Steven Kiel of Arquitos Capital Partners. At the bottom of this page, there’s a teaser copy of the new issue.
Interview With Steven Kiel Of Arquitos Capital Partners
Arquitos was founded with a goal of emulating the success of Warren Buffett’s early partnerships. Even your mission statement is lifted directly from the Buffett Partnerships. A lot of people have tried to replicate Buffett’s success in the past and failed. What made you think you could succeed?
Buffett has been an inspiration to a generation of investors, myself included. Investors should learn from him, but ultimately you have to apply your own personality to the way you approach research and the construction of the portfolio. You should try to emulate the process, but in a way that fits you.
The goal for any investor should be to compound funds at a better than average rate with less exposure to long term loss of capital. How do you improve on that statement? It’s kind of like the Declaration of Independence. The ideals stand the test of time. If you were starting a new country, just copy the first 273 words of the Declaration of Independence as the foundation of your country. That’s how I felt about the mission statement.
As far as what made me think I could succeed, it’s a constant process of proving it. Just like a baseball player, you’re only as good as your last year.
Do you have three special investment buckets similar to those of Buffett?
I break the portfolio into several segments but in a different way from the Buffett Partnership approach. We have core holdings that I would like to own as long as the company has internal reinvestment opportunities and as long as they effectively allocate capital. I also have a portion of the portfolio focused on arbitrage or special situations such as mergers, spin-offs, or other short term opportunities. I also keep on a more general market hedge.
Arquitos returned 54.9% for its investors during 2016, a tremendous result. What would you attribute this return to?
Well, we definitely had a great year. I would not expect that our run over the first five years of the fund is sustainable, but I’ll certainly keep trying. It’s important to remember that you can only control the inputs, not the outputs. Because our portfolio is fairly concentrated (12-20 stocks) good results will come when the largest holdings do well. The results haven’t historically been connected to the general markets. The timing is just luck and can’t be controlled, but the goal is to be consistent on the process. This may sound trite, but our biggest holdings went up the most, Intrawest Resorts, MMA Capital, Berkshire LEAPs, and Bank of America warrants. There is still value in all of them, though I exited the Berkshire LEAPs.
Your best-performing stock last year was Intrawest Resorts Holdings. Can you give a brief description of what happened here and how you stumbled across to opportunity?
That one is a good example of the importance of being flexible. Intrawest was cheap on the merits, but what caused me to make it our largest holding in the beginning of 2016 was their tender offer. They had sold their time share business and bought back about 12% of their outstanding shares. Fortress owns 60% of the company and did not sell any shares despite having a need to exit the investment. Clearly, Fortress thought that shares were trading too cheaply and it seemed to me that they had a plan to realize the value. Their plan seems to have come to fruition and recently Intrawest announced that they were putting themselves up for sale. Shares have passed $20, up from the $9.00 tender offer price a year ago.
On that note, what do you look for when you're assessing a potential investment, what makes you say, “yes we want that” or “no we don’t”?
There are patterns. The Intrawest example is a good one because the situation was similar to previous investments I’ve made and witnessed where there was a large tender offer and the controlling shareholder does not participate. Seeing that definitely makes my ears perk up. On the negative side, there are a lot of things that make me want to stay away. The biggest ones are ethics issues. There are too many opportunities out there to get hung up with a company that has a poor culture.
So a company’s management plays a significant role in your decisions?
It plays a big role, especially with regards to incentives. My favorite investments are ones where the management is effectively allocating capital. The best companies are the ones that have high returns on equity and continue to find internal reinvestment opportunities. Those are the ones you can own for a long time. Sometimes the managers are inherently good capital allocators. Other times they are responding to incentives that cause them to focus on returns on invested capital and cash generation.
Do you get involved with managements at all in an activist way?
I’d prefer not to. The frustration of dealing with negative things just kills too many brain cells. As a passive investor if management is doing something I don’t like, it’s just better to move on. Chances are they’ll continue to frustrate you. The one time I didn’t follow that path led to me taking over Sitestar (OTCQB:SYTE) with two other partners, Jeff Moore and Jeremy Gold, and led to a lot of work to clean the company up. I wouldn’t want to go through that experience again though we have a lot of interesting opportunities within Sitestar. Once was enough for me. I have supported other activists on occasion and am happy to ride their coattails.
Let’s move on to another of your winning positions last year, which was Berkshire Hathaway. You own the stock through long dated options. Can you explain the logic behind this trade?
Berkshire traded below 1.3 times book value at the beginning of 2016 and even lower if you considered what they were likely to report the next quarter. Of course, Buffett has said that he will buy back shares under 1.2 times book value. Given that situation, the easiest thing to do is either buy shares directly or buy long dated call options at the 1.2 times book strike price. I bought the call options. I don’t typically buy options, but you had to believe that at some point in the next two years either the multiple would be higher than what I bought the options at or book value would have grown or both. It turns out both happened and we made a really nice return. The risk/reward profile was better for the long dated options than the stock. It was a pretty simple thesis. It really required willpower more than anything else.
Do you do any shorting and if so do you have any short positions on at the moment?
I don’t have any short position though I keep a small hedge on. I just haven’t had luck with specific company shorts. It doesn’t seem suited to my approach.
Sure. Moving back to your investment strategy, reading through your letters to investors, you seem to focus on a company’s Net Operating Losses (NOLs) more than any other metric when analyzing its future potential. Why do you prefer to use NOLs to evaluate a company, rather than more traditional valuation methods?
That may be a trade that goes away if corporate tax rates are lowered. Tax reform would bring other opportunities such as partnerships converting to C corps, so I’m keeping an eye on any changes that occur....
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