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January 27, 2014 Dear Investori: Our portfolio rose 10.75% in December of 2013, bringing our full year (unaudited) return to 60.68%. This compares to the S&P 500s gain of 32.39%.

Monthly Returns

12.00% 10.00% 8.00%

6.00% 4.00% 2.00% 0.00%

(2.00%) (4.00%)


Feb Mar Apr May Jun


Aug Sep

Oct Nov Dec


S&P 500 Total Return

Year-to-Date Returns

50.00% 40.00% 30.00%

20.00% 10.00%
0.00% Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec


S&P 500 Total Return

12 Desbrosses St New York, NY 10013 646-912-8886

Page |2 Although 2013 was Incandescent Capitals inaugural year, I have personally managed money for friends and family since 2009. Gross returns since inception are thusly:
Return 50.75% 18.78% 2.28% 16.38% 60.68% 27.92% S&P 26.46% 15.06% 2.05% 16.00% 32.31% 17.91% Difference 24.29% 3.72% 0.23% 0.38% 28.37% 10.01% HFRX1 13.40% 5.19% (8.88%) 3.51% 6.72% 3.73% Difference 37.35% 13.59% 11.16% 12.87% 53.96% 24.19%

2009 2010 2011 2012 2013 CAGR

And here is how $100,000 would have compounded versus those two benchmarks if it was invested at the end of 2008:

$300,000 $250,000



$150,000 $120,069

2008 2009 2010 2011 2012 2013




All figures above are gross of fees (that is, before any fees are deducted). Since each investor in Incandescent Capital has the option to negotiate different fee arrangements, net returns will vary. For 2013, if you elected our standard 20% performance fee (no hurdle, no management fee) arrangement, your net return would be around 48% compared to your gross return of 60.68%. Also, depending on when your account was on-boarded, your results may differ from the main reference account reported above. It takes a bit of time to sync each account to the same exposure as I buy/sell according to the ebb and flow of the market. As always, your patience is asked for as I build your new portfolio up, but rest assured: what you own, I own. I am committed to eating my own cooking2.

The specific index here is the HFRX Global Hedge Fund Index, widely used index to praise or pan hedge funds in the press. The main reference account statement is available upon request from any investor.



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A Nuanced Discussion of Concentration vs. Diversification

In my annual letter last year, my comment regarding my 2009-2012 track record was: pleased, but not satisfied. With the exception of 2009, I did not separate us very much from the S& P. The problem was not picking poor stocks, but rather, being far too conservative and holding excessive cash, sometimes up to 30+% of our portfolio. Opportunities were out there, but I was swinging tepidly. When 70 mph fastballs are floating down the center of the plate, it behooves the batter to swing for the fences. 2013 was a different story, and I am pleased (and satisfied) to have corrected my course of action. Except for a brief couple of weeks during the debt ceiling crisis, our cash balance was kept around the optimal 10-15% range. More importantly, I concentrated the majority of our funds in our top ideas, several of which I will specifically discuss in a later section. This was the key to our outperformance this year, and it is critical that all Incandescent Capital investors understand the philosophy behind this strategy. Here are how our positions look as a percentage of total portfolio and its geographic split:

Position Size by %

Geographic Split

10.2% 32.7%
43.2% 67.3% 11.0% 13.1% Canada USA

As of the end of 2013, cash (that lime-green beveled slice) was 10.2% of our total portfolio. Our biggest position accounted for 43.2%, and our top three non-cash positions occupied around 2/3rds of our total portfolio.



Page |4 The constituents of our portfolio have largely stayed the same since I last shared this snapshot with you at the end of Q3. However, the percentages have shifted even more top-heavy (and Canadian) thanks to our largest positions 85% appreciation in Q4. Honorable mention goes to a smaller 5% position that appreciated 59% in Q4. All other positions averaged a modest 6% appreciation for the quarter. Needless to say, our book is concentrated. And since concentration is the antonym of diversification (practically canon law in asset management) I feel I have some explaining to do. Imagine a fund with the following performance over five years: -20%, -10%, 5%, 65%, 25%. Now imagine another fund that performs thusly: 5%, 10%, 6%, 8%, 4% The first would return $155.93 on $100 invested for an annual growth rate of 9.3%, while the second would return only $137.51, an annual growth rate of 6.6%. Which one would you prefer? This is not a trick question. Even though the first fund is more profitable, many people prefer the second, less profitable one because its less volatile. We humans are psychologically more sensitive to potential losses, and are willing to forgo potential profits in the spirit of loss aversion. Diversification, then, is touted as a way to spread out risk and minimize volatility across a portfolio. Investors gravitate towards smooth, predictable returns and shun lumpy, but possibly superior, returns. And Wall Street is all too happy to create products that cater to such preferences. Witness the explosive rise of ETFs 3 , which, according to Investment Company Institute, grew from $83 billion in net assets in 2001 to $1,337 billion in 2012. Even a small 0.50% expense fee applied to $1,337 billion results in $6.7 billion in revenues, with each incremental dollar representing almost pure profit. Its no wonder diversification is preached high and low. Investors who buy diversified funds are psychologically wired to sleep better at night, and Wall Street collects pure profit off the top. Best of all, there is no overt culpability! Instead of bearing the risks of the markets, wealth managers have surreptitiously transferred it onto the slumbering shoulders of diversified investors. Good year, bad year, whats the difference? Theyll take that management fee regardless, thank-you-very-much.

Exchange Traded Funds, which are basically mutual funds with the added benefit of intraday liquidity. Although an ETF is technically just a legal structure, it is most often associated as being an efficient way to diversify.



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Source: Investment Company Institute (

Youd have to admire what a wonderful model that is if you d idnt wake up one day and realize your portfolio was suffering from mediocre performance. Because inevitably, the quality of ideas diminish the more one diversifies. Global capital markets are extremely competitive, and truly good ideas are scarce. I dont believe it makes much sense to invest equal amounts in our best idea as our hundredth best idea just for the sake of smoothing out our monthly P&L4. The truth is, the equivalence between volatility and risk is an imperfect one. Instead, the more appropriate equivalence is perhaps volatility and perceived risk. It is a relative measure, in which investors gauge riskiness based on how aggressively other investors are buying or selling. Here is where I ply my trade, where misperception begets opportunity. If such an opportunity is within my circle of competence and the misperception generates a level of volatility that creates attractive prices, I pounce. The trade-off is we will suffer volatility, and suffer the perception that we hold risky stocks. Our performance may resemble the peaks and valleys of imaginary fund #1 above. But if we do enough homework and double-check it diligently, it is a proven methodology that will result in outperformance in the long run5.

I feel obligated to note that diversification for folks uninterested in stock picking is an adequate strategy I would happily recommend ETFs of broad indices to those who do not have the inclination to invest with an active manager. My ire here is primarily directed towards funds that market themselves to be alpha generators, but yet are crawling with ETFs and end up inevitably correlated to the indices theyre supposed to be beating. Heres Buffett in 1998 speaking with University of Washington students: Youll see times when yo u get chances to do things that just shout at you. When that happens you have to take a big swing. That is no time to be reading a book on the theory of diversification. [] You take your thumb out of your mouth and barrel in. (



Page |6 So, I choose to concentrate. I do not choose to hide behind the veneer of diversification. My compensation and amount of kudos should be correlated with our long-term results. If I do poorly, it is my fault. I cannot blame the market, and I deserve to have capital pulled from my management. But hopefully, I will continue to do well, and we will all prosper. *** Happily, 2013 was a prosperous year for us all. However, it is unlikely I will be able to replicate 60% returns any time soon, much less on an annual basis. I consider this years results to be an outlier. My primary goals are and will always be: 1.) Dont lose money 2.) Outperform during bear markets 3.) Outperform over a multi-year horizon Gun to my head, The Number would be 20%, which represents a roughly 10% advantage over the long-term returns of the stock market as a whole. But rest assured, Im not about to take the year off to rest on my laurels. Investing is a business that has never failed to humble even the most brilliant, Einstein-esque IQ working 18 hours a day. I intend to build as big a lead as I can to buffer against the inevitability of an underwhelming year. Now lets talk stocks.

Yellow Media Limited

Ill jump right to the chase. Yellow Media (TSE: Y) was our biggest winner in 2013 by far, on both a percentage and a dollar amount basis. Here is how we came to be invested in the name. Back in 2012, the company was a heavily indebted dinosaur that could no longer afford to pay its debtors. Its business of selling and printing yellowpage ads in Canada were vanishing in this modern digital era. Shares of their common equity plummeted down to a nickel per share upon news of a proposed corporate restructuring. Dying business, penny stock, bankruptcy looming. Whats not to like, right? As Howard Marks6 once said, there are no good or bad securities, only good or bad prices. For value investors, it was a beautiful setup. We like to poke our noses in places where investors have fled. Mike Burry7 calls it being attracted to the ick factor.
6 7

Founder & Chief Investment Officer of the famed investment company Oaktree Capital Management. One of the protagonists of the book The Big Short, who ran a successful value fund that made hundreds of millions shorting subprime mortgages in 2007-2008.



Page |7 The Yellow Media story actually ended up being two chapters. Initially it was simply conceived as a low-risk, low-return arbitrage play, but ended up being one of the most attractive opportunities I had ever seen.

The Arbitrage
The companys restructuring plan involved exchanging new common shares for a variety of different securities in their original capital structure. In plain English: imagine that you went and borrowed a bunch of money from a bunch of different people, and then woke up one day realizing you couldnt possibly pay all of them back. So you gather all of your debtors into a room and agree to garnish a percentage of your future salary to them to satisfy their claims. However, some debtors are more important than others. Maybe one of them is affiliated with the Dixie Mob, who demand a bigger cut of your salary or else. And maybe another is your grandmother, who kindly tells you to just pay her back whenever you can. As tongue-in-cheek as that example is, its basically how corporate restructurings work. The company is re-imagined as a pie that gets divvied up to people with claims, some of whom are contractually superior to others. Equity holders are at the bottom of the totem pole. They are the kindly grandmothers who, in most restructurings, get nothing. In Yellow Medias restructuring plan, however, everyone got a slice of the new pie. Even better yet, within the scrum, there existed an arbitrage opportunity. One could buy the preferred shares, which were allocated an X amount of the new pie, and then short an equivalent dollar amount of the common shares, which were allocated a Y amount of the new pie, and end up with a tiny slice that costs basically nothing. In other words, one could create X-Y = Z, where Z is a positive integer, for free (minus broker fees and short-borrowing costs). That was our initial foray into Yellow Media. By the end of 2012, the restructuring was approved8, and the new Yellow Media, with much of its debt shed, began trading as Y on the Toronto Stock Exchange.

The Fat Pitch

Y debuted at around $6 per share9, which meant the market was valuing the total equity of the newly restructured enterprise at under $200 million. To put that into context, its less than the amount of free cash flow (FCF) the company generated in 2012, even under its thenunsustainable debt burden. I had never seen a stock of a going-concern trade at less than a

We did not profit as much as we probably should have from this trade. I sized it conservatively because there was an outside chance the restructuring plan would be kiboshed by disgruntled convertible debenture holders. Not comparable with the $0.05 per share price mentioned above the share count was dramatically shrunken post-restructuring.



Page |8 multiple of its FCF10, and was astonished at the incredible negativity towards the company despite having scrubbed off $1.5 billion of debt. By then, I had become intimately familiar with its business operations. Its true that their print business was shrinking dramatically, but hidden in the miasma was actually a fast growing digital business already constituting 1/3rd of Yellow Medias revenues. All they had to do was to allow print to slowly die off and redirect its still-prodigious cash flows towards paying down expensive and restrictive debt11. Keep the momentum going on the digital side, and within a year or two, it would become quite clear that Yellow Media would survive, and perhaps even thrive, in its new incarnation. Bolstering my belief were the blueprints provided by the already successful print-to-digital transformations of Solocal and Eniro, the yellowpages of France and Sweden, respectively. Most importantly, it was nearly impossible for me to conceive of any scenario in which Yellow Media would go bankrupt, which is basically what their $6 per share IPO seemed to suggest. Even if I assumed their print business vanished overnight (2/3rds of their entire business) Y would still be a cheap stock valued at less than 10x FCF. There are slow floating 70 mph fastballs down the center of the plate, and then there are softballs perched on tee-ball stands. I swung and made Y our biggest position, putting 30% of our portfolio into shares at prices between $7 and $9. Y ended 2013 at $20.56, a ~150% gain from our cost basis. All the cash flows from their attriting print business has indeed gone towards paying down debt, which over the course of the year has been cut from $800 million down to under $600 million. Meanwhile, Yellow Medias digital business has grown to 43% of their revenues, and as a delightful cherry on top, they poached a top executive from Solocal to be their new CEO. We still own Y as of this date, although I have begun to book some of our profits. What was originally conceived as a simple arbitrage designed to siphon up a few nickels from a dark corner of the couch turned out to be a couch sitting on a gold mine. Be forewarned, ideas like this are rare. It is impossible to predict when (or if) we will have another softball like this teed up for us again.


FCF is a non-GAAP metric used by many investors to estimate a companys true, normalized earnings power when good old fashioned net earnings is polluted by one-time costs/gains. Which, in the spirit of a penny saved is a penny earned, is one of the su rest ways of building shareholder value.




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Advanced Emissions Solutions, Inc.

Advanced Emissions Solutions (ADES) is an environmental technology company providing solutions to dirty coal-burning utilities. It is a complex story involving public policy, tax credits, and joint ventures (JV). We like that. Complexity is an area where mispricing often occurs. If youre willing to roll up your sleeves and incur some elbow grease, good value can be found. ADESs main business is building facilities that refine raw coal by reducing the amount of nitrogen oxide and sulfur dioxide/mercury that gets emitted when burned. Basically, they take dirty coal and make it cleaner. The EPA incentivizes this by rewarding those facilities with a tax credit. Tax credits are valuable because they are like gift cards to pay taxes with. ADES monetizes these tax credits by leasing their facilities to an entity wishing to reduce their tax bills. In return, the monetizing entity pays ADES rent. Voila, cash flow. If the above paragraph made your eyelids droop a bit, know that I simplified it as much as humanly possible. There is a mountain of details that are snooze inducing, such as the JV structure with Goldman Sachs, the private letter rulings that must be issued by the IRS before tax credits can be claimed, the fact that ADES intentionally retains facilities to reduce their own tax liabilities, et cetera. Modeling out just exactly how cash will flow from monetized tax credits through the Rube Goldberg machine of their various corporate structures is fraught with hairiness; its not difficult to imagine an analyst just tossing ADES into the too hard pile, especially given its (at the time) sub-$300 million market cap which makes it too small to move the needle for the billion dollar funds of the world. The pitch could basically be boiled down to this: ADES is working on bringing 28 facilities online. At the time, only 4 were monetized, 2 were being used as permanent tax credit generators for ADES itself, and the rest were in various stages of build-out or permitting or negotiations. The primary risk was the unpredictable timeline of when their facilities would get approved and monetized. Delays are inevitable when a circus of regulators, IRS rulings, lawyers, and bankers are involved. However, at the price where we started buying shares (low $20s during Q4 of 2012), we were essentially paying for the 6 operational facilities and getting the others for free. Thats the kind of risk/reward asymmetry I dig: if ADES fail to get their facilities monetized, we sit on dead money, perhaps a small loss, and wait it out. If ADES actually does what they say they will, we enjoy a significant windfall. By the end of 2013, ADES had 12 facilities operating, 8 of which were monetized, basically doubling what they had in the beginning. The stock stair-stepped its way up upon each monetization announcement and ended the year at $54.23, an over 100% return on our initial investment. We have booked much of the profits, but continue to hold a decent sized position with the hope of buying more should negative investor sentiment resurface and offer us a sale.



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AMCON Distributing Company

On the spectrum of exciting stocks, AMCON Distributing (DIT) would be at the far end of dull and boring. But as my former business school professor once told me, if you want excitement, go skydiving. In business and investing, what you want instead is predictability, and predictability is boring. DIT was so boring that it was our biggest position at the beginning of 2013 (before I glommed onto the Yellow Media story), constituting 17% of our portfolio. DITs business is 1.) Wholesale supplying gas station convenience stores, liquor stores, etc. with cigarettes and candies and whatnot, and 2.) Retail operating organic supermarkets. Nothing that gets anybody excited, thats for sure. Add on the fact that it is a $50 million market cap with maybe 1,000 shares traded per day and you have a stock that is pretty much out of the purview of 99% of all investors. Heres why thats good for us. A simple, predictable business like that is easy to project earnings and cash flows for. Confidence in such projections lead to confidence in the fair value of such a business. And with a solid fair value in mind, its easy to step up and buy when Mr. Market offers to sell it for a discount. Illiquidity typically do not deter me if I am confident in the underlying fundamentals of the stock. All it means is it will take some time to build a satisfactory position and some time to exit when fair value is reached. Patience is a virtue, and in todays high frequency trading world, it can also be a real edge. Bolstering my confidence is the steady guidance of their CEO, Christopher Atayan, a private equity executive who took control of DIT in 2006 when the company was a smoldering heap that was over-levered, losing money, and about to be delisted from the stock exchange. He simplified the organization, sold a money losing division, and built a staff that instilled an attention to details. His annual letters sparkle with clarity12: maintain liquidity, maintain a sustainable debtto-equity capital structure, and then focus on making the highest return on invested capital. Business 101, right? Most importantly, Atayan also put his money where his mouth is by buying a 37.5% stake in the company, all of which he still holds to this day. We started building our position in late 2011 with a cost basis of $61.80. Throughout the course of a year and a half it would rise and dip between $60 and $70, and I would opportunistically trade around a core position. When DIT breached the $80s in Q3 last year, I sold. Overall, we enjoyed an IRR north of 20%. This was an investment that was never going to be a double or triple. What it was was a delectable combination of predictability, obscurity, and safety a steady compounder that we could load up on and still sleep comfortably at night.


And repetitiveness a compliment, actually, because its a byproduct of how pervasive his philosophy is.



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EchoStar Corp.
Our involvement in EchoStar (SATS) began back in 2009, one of our longest tenured names in our portfolio. The company was originally spun-off from Dish Networks13 (DISH) in 2008 to become the holding company for its satellite and set-top device business. Corporate events like spinoffs often create opportunities for several reasons. Often, investors will sell the spun-off stock because it doesn't fit their portfolio mandate, thus creating downward pressure on its price for no fundamental reason. Furthermore, a spinoff creates a more focused and transparent company, no longer relegated as a segment inside a larger company. That gives both investors and management more clarity, thereby raising its value over time. Two additional factors made SATS even more tantalizing: 1.) It was trading below tangible book value, and 2.) Charlie Ergen remained its chairman and largest shareholder, controlling over 50% of its stock. A sub-1x tangible book value spin-off with a captive customer like DISH and hard-to-replace assets like a fleet of satellites would arguably have been reason enough to warrant an investment. So would a rough sum-of-the-parts valuation exercise, whereby simply adding up its non-core assets (over $1 billion in cash and investments) and the present value of its earnings power equaled a per share fair value of roughly twice our cost basis of ~$20. But to me, the best part was having Charlie Ergen on our side. Ergen, who made his living playing blackjack and poker in his youth, is one of the great entrepreneurial stories in American history. Legend has it he started DISH with his poker buddy, his wife, a pickup truck, and two of those big ol C-band satellite dishes. On the way to their first installation, the truck hit a bump on the road and one of the satellites fell off and broke14. Thirty years later, through grit and guts, he is worth something like $12 billion and is ranked #32 on the Forbes 400. He could be retired on a mega yacht somewhere, but he remains heavily engaged in all his enterprises. Business schools typically teach people to discount stocks dominated by a controlling interest because it supposedly turns corporate governance into a de facto corporate dictatorship. But dictatorship can be a good thing if its benevolent. Warren Buffetts Berkshire Hathaway trades at a premium to where it otherwise might because hes the emperor. Likewise, if I can get in, discounted no less, on a Charlie Ergen investment, Id do it ten times out of ten in a cocaine heartbeat.

13 14

For my non-U.S. readers, Dish Networks is a major satellite TV provider here in the States. Sourced from a rare hour long interview here:



P a g e | 12 We bought slugs of SATS for $20 in late 2009 and early 2010. I doubled down in 2011 when it pulled back to $20 again. And since then it has steadily marched up to $50, where I finally sold out last October because, alas, investing is a game of opportunity costs, and SATS had finally reached fair value. But I continue to keep tabs on Charlie Ergen, who has recently been making a push to enter the wireless arena to duke it out with the big mobile carriers. You better believe I am eagerly awaiting any future opportunities to bet with Charlie once again.

The Theory of Cash Proxies

Loyal readers of my letters may remember me writing about the alpha generating power of cash proxies securities that, for one reason or another, become mispriced temporarily in a quantifiable way (e.g. forced liquidation from a major shareholder, updated dividend policies, churning shareholder bases, and in some cases, merger arbitrage), but have a high probability of reverting to the mean in a short period of time. I call them cash proxies because they are places where I deem safe enough to park our excess cash and are liquid enough to trade out of should a better opportunity suddenly present itself. Two successful cash proxy investments we enjoyed in 2013 were Frontier Communications (FTR) and Chorus Aviation (TSE: CHR.B). The thesis behind both are similar enough that Ill generalize. Both have high volume, predictable businesses that generate gobs of cash flows. Both experienced distinct corporate events that caused their stocks to get crushed big dividend cuts15. However, their dividend cuts were prudent corporate decisions that actually strengthened the balance sheet of each company, and both cut deep enough so that cash flows covered the new dividend yield at 2-to-1 or better. Despite that, both sold off such that even the new yield hit double digits16 . Well-protected 10-15% yields on stocks with its would-be sellers flushed out? Yes, please! Thats a superior risk/reward to just about every fixed income option out there. We bought FTR each time it dipped below $4.00, which was its magical 10% yield mark, and we bought CHR.B when it touched $2.00, its 15% yield mark. A couple of quarters and dividend payments later, we rung the register in FTR at $4.61 and CHR.B at $2.56 for solid double digit total returns17.


For FTR, it was actually collateral damage from a competitor, CenturyLink, cutting its dividend. FTR had reduced theirs already a year ago but skittish investors feared yet another cut. For CHR.B, it was a precaution against possibly losing an arbitration case. Why? Pissed off investors. Never underestimate the irrationality caused by heightened emotions. CHR.B then proceeded to win their arbitration case, after which management bumped up the dividend and the stock soared above $3.50. Cest la vie!

16 17



P a g e | 13 The miracle of compounding is such that steady gains in boring names like DIT, SATS, FTR, and CHR.B will guarantee you wealth over time. Home runs like Y and ADES are rare, and although of course welcome, one should approach the plate with the goal of not striking out. For those who follow Major League Baseball, the analogy is its better to be Joey Votto (high batting average, low strikeouts, occasional power) than Adam Dunn (low batting average, high strikeouts, but exceptional power). Of course, both are preferable over Mario Mendoza, whose sub-.200 batting average is taken to define the threshold of incompetent hitting, a.k.a. The Mendoza Line.

Biggest Mistake: J.C. Penney

It is certainly tempting in a year where you beat the S&P by 28 points to sweep your mistakes under the rug. And although it is fortunate my mistakes in 2013 were limited and low-impact vis--vis our overall portfolio, its important still to acknowledge them, especially since mistakes are fertile ground from which to cultivate lessons18. In 2012, my bane was Real Goods Solar (RSOL), a stock in which we booked a 50% loss that cost us 4-5% of overall portfolio performance. Worse, it proceeded to quadruple six months after I sold. Anyway, I keep RSOL on my screen every day to remind me of the lessons learned from that debacle. I wont rehash the whole story, but for those who did not get my 2012 Annual Letter, feel free to ask for a copy wherein I lay my humiliation out in full gore. In 2013, no loss exceeded 0.50% of our net asset value. However, the one that stands out to me is J.C. Penney, the iconic American retailer that is currently on life support. The background: in 2011, a famous hedge fund called Pershing Square took an 18% stake in the company and ousted its incumbent CEO, Mike Ullman, for Ron Johnson, then the SVP of Retail at Apple the man behind the wildly successful Apple Stores. On paper, this was amazing news. In addition to building Apple Store revenues from zero to a billion in two years, Ron Johnson also had years of experience as VP of Merchandising at Target during Targets ascent. Applying his magic to a brand like J.C. Penney should be a question of when, not if. Giddy investors pushed JCP above $40 by early 2012, but what really fanned the flames was Ackmans now infamous presentation at the Ira Sohn Conference titled, Think Big, in which he speculated that if everything went right, JCP could be worth $125 by 2015 19. Its worth noting that I, although impressed like everyone else, had yet to invest our money at this point. Chasing momentum is not, and will never be, my cup of tea.


Real, money losing mistakes, not those humblebrag-ish mistakes of omission that so many fund managers cheekily trump, e.g. I knew it was a home run my biggest mistake was not buying more! It was impressive a 60+ slide deck chock full of numbers and graphs:




P a g e | 14 Long story short, Ron Johnson failed to deliver. He emptied the companys cash coffers and embarked on a radical redesign of the entire store base. He made sweeping changes such as eliminating all coupons and discounts. On the surface, everything looked great. I mean, even I started to shop there. The problem, which is so obvious and simple in hindsight, was that folks like me are not their core customers! Penney instead served cost-conscious shoppers who cared more about their coupons than how pretty the stores looked. The company started to lose money with breathtaking speed. 25% of their annual revenues, about $5 billion dollars, disappeared during Ron Johnsons tenure. Their suppliers started freaking out. Under intense pressure, Johnson was ousted and the stock collapsed into the single digits. Other famous hedge funds like Perry Capital and Hayman Capital started getting involved and, emboldened by their implicit due diligence, I started buying JCP common shares. It is only by complete luck that I managed to sell out at breakeven after quickly realizing the danger of trying to catch that falling knife. But ever persistent, I thought I saw another cash proxy opportunity in JCPs unsecured bonds when the 5.65% 2020 20 traded down to 75 cents on the dollar, implying a yield of 11%. The company had brought back Mike Ullman, who immediately reimplemented the old couponing regimen. If he could avoid bankruptcy and stabilize the ship, surely the bonds are worth near-par. As of today, the story remains unfinished. Those bonds still trade in the 70-75 cent range, but thrash with astonishing volatility as investors and various press outlets continue to actively speculate on Penneys ultimate survival/demise. I lost my nerve and sold. Again, I credit fortune for escaping with just a small loss, but the lessons and scars I carry away are more moral than monetary. JCP was a story I got sucked into and thought I could play. But the truth is, I had no edge. Without an edge, I have no true conviction. And without conviction, I would be shaken out by volatility, the aftershocks of big hedge funds duking it out. Honestly, I have no idea if Penney will go bankrupt or if Ullman can ultimately save the company. I might as well go flip a coin a poor risk/reward not worthy of our precious capital.

The broad stock market is, in my opinion, fully valued today. Pay no attention to those who claim the market remains cheap because the P/E of the S&P 500 is only 15x. The flaw in that argument is that the denominator, the earnings, are cyclically inflated. Corporate profit margins are at all-time highs thanks to ultra-low interest rates (companies are paying less for their debt) and political/economical forces that favor capital over labor (companies are paying workers less thanks to declining power of unions, outsourcing, technology, et cetera).


Bond shorthand for a security with a par yield of 5.65% maturing in the year 2020.



P a g e | 15 This has historically been unsustainable. The following chart, courtesy of research from mutual fund manager John Hussman, shows a strong correlation between corporate profits as a percentage of GDP (blue line, left axis) and their subsequent 4-year annual profit growth/decline (red line, right axis). Basically, the more corporate profits grow as a percentage of our total pie, the more they shrink in subsequent years a pattern that has repeated itself for the past 60 odd years:

Source: Hussman Funds (

If you think about it, rates that are already rock bottom can only rise, and underpaid workers in a capitalistic democracy will organize to regain their share of the GDP pie. Witness the demands of raising the minimum wage. Witness Barack Share The Wealth Obamas sweeping victory in 2012 over Mitt Private Equity Tycoon Romney. Witness the Occupy Wall Street phenomenon. CEOs and their 1% compadres are richer than ever, and the rest of America is fed up. Whether or not that is fair is irrelevant. Those are simply clear, common sense reasons why corporate profit margins inevitably revert to the mean over the long run.



P a g e | 16 I point this out as a general warning, not as a prognostication on how the stock market will perform this year. Its certainly possible the market will rip another 30%. Mankind is capable of bidding up anything, be it profitless tech stocks, CDOs, baffling Damien Hirst artworks21, and even tulips22. All I know is, stocks arent cheap, and I wont buy whats not cheap. Should the S&P replicate 2013s magnificent performance again, you should expect Incandescent Capital to struggle to keep pace. Nonetheless, I am confident in our current portfolio of securities. Besides Y and ADES, we hold several other names that have the potential to double, as well as a couple of boring-but-steady compounders that should grind out predictable earnings quarter in and quarter out. While it is extremely unlikely we will achieve anywhere near 60% returns again anytime soon, I fully expect our portfolio to handily outperform the broad market on an annualized basis over the next few years. I hope you will stay for the ride, however turbulent it may get. As always, I welcome any questions and/or feedback. I wish you and yours a prosperous and joyous new year.


Eric Wu

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Check out this doozy that went for $12 million: In 1637, one freaking tulip was going for more than 10x the annual income of a skilled Dutch craftsman.