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February 18, 2019

Dear Investori:

Our portfolio declined -19.54% in Q4 of 2018 versus the S&P 500‘s decline of -13.52%. The
charts below show our performance figures for the full year and since inception:

Incandescent S&P 500 Difference

2018 Year -21.68% -4.38% -17.29%
Since Inception (72 Months) 73.88% 99.00% -25.12%
CAGR 9.65% 12.15% -2.49%

Returns Since Inception

Incandescent S&P 500 Total Return





















Jul-18 Last 12 Monthly Returns

Incandescent S&P 500 Total Return








222 Broadway, 19th Floor • New York, NY 10038 • 646-912-8886 •

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Although Incandescent Capital was officially founded in 2013, I have personally managed
money for friends and family since 2009. Gross returns (unaudited) from my personal reference
account (where I keep 95% of my net worth) since then are thusly:

Incandescent S&P Difference HFRX1 Difference

2009 50.75% 26.46% 24.29% 13.40% 37.35%
2010 18.78% 15.06% 3.72% 5.19% 13.59%
2011 2.28% 2.05% 0.23% (8.88%) 11.16%
2012 16.38% 16.00% 0.38% 3.51% 12.87%
2013 60.68% 32.31% 28.37% 6.72% 53.96%
2014 5.31% 13.69% (8.38%) (0.58%) 5.89%
2015 3.69% 1.38% 2.31% (3.64%) 7.33%
2016 2.52% 11.98% (9.46%) 2.50% 0.02%
2017 23.66% 21.83% 1.83% 5.99% 17.67%
2018 (21.68%) (4.38%) (17.30%) (6.72%) (14.96%)
CAGR 14.02% 13.11% 0.91% 1.54% 12.47%

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


$450,000 $371,298





$150,000 $116,567
2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018

Incandescent S&P HFRX

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 2018, if you elected our standard 20% performance fee (no hurdle, no management fee)
arrangement, no fee was charged; and furthermore, going forward, no fee will be charged until
the high-water mark set at the end of 2017 is regained.

This is the HFRX Global Hedge Fund Index, a widely used index to praise or pan hedge funds in the press.

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Customary Preamble

For the benefit of new investors receiving this letter, allow me to repeat what I‘ve written in
previous memos: short-term performance numbers as precise as the ones given above should be
taken with a grain of salt. Industry standards compel me to report the numbers, but
philosophically, I think of our investments like a business owner, and business owners are
typically not in the habit of running out and getting valuation opinions on their enterprises on a
monthly basis. Indeed, the only times that price should matter is 1.) when a business is being
bought, and 2.) when a business is being sold.

I generally save discussions of specific securities for my annual letter (although this is not an
iron clad commandment as I will occasionally bring up names as examples for a discussion topic
I am musing on). The reason behind the ―secrecy‖ is multi-fold.

1. We often traffic in illiquid securities whose price can easily be manipulated with a few
hundred shares,
2. This letter goes out to people who are not currently invested with us and I do not want to
promote to them a long/short recommendation that I would not be accountable to
if/when the facts change, and
3. It helps me avoid the psychological bias of wanting to defend a position just because I
made it public, even if circumstances change and I ought to reverse course.

Item number three is probably the most important. Value investing is a constant battle against
emotions and irrationality, and erecting psychological defenses against innate human biases is
critical2. It naturally becomes more difficult to admit mistakes if ego gets involved, and believe
me, mistakes will be made. So it‘s far better if I simply not go there at all.

Final housekeeping item to note: Your results may differ slightly from the main reference
account reported above depending on the timing of your various capital contributions. 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. Your patience is asked for as I tune your individual portfolios, but rest assured:
what you own, I own. I am committed to eating my own cooking3.


Charlie Munger has called understanding the psychology of human misjudgment a “superpower”.
The main reference account Interactive Brokers statement is available upon request from any investor.

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Portfolio Review
Here are our positions sizes by percentage and their geographic split as of the end of the quarter:

Position Size by % Geographic Split





Cash Canada USA

And here are our positions broken down by investment ―type‖ and by sector:

Investment "Type" * Sectors

10.9% Other
13.1% Tech
Mispriced 10.1%
41.6% Consumer
Compounder Cyclicals
47.4% 8.1% Financials

*Updated: 2018 Q4

As a reminder: ―Compounders‖ are businesses I believe have long, predictable runways for
growth that we‘ve invested in at fair, if not arguably bargain prices. ―Mispriced‖ are businesses
undergoing transformation or have fallen out of favor with the market and are thus in my
opinion widely misunderstood and misvalued. ―Special Situations‖ are businesses with hidden
assets and/or have potential catalysts that will unlock value in the near future, e.g. spin-offs,
buyouts, arbitrage, and the sort.

The ―Other‖ sectors we have investments in include (one of each): conglomerate, industrial, and
basic materials.

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I began last year‘s annual letter to you by drawing your attention to our larger than usual cash
balance of ~20% at year-end 2017, the result of an inexorable bull market that had booked nine
straight years of gains. That streak finally ended in Q4 in dramatic fashion. And hence, our cash
balance, which I typically like to keep at around ~10% of assets, is now nearly fully deployed,
with only 1.6% remaining idle.

While it is always at least a little uncomfortable to suffer a double-digit drawdown as we have,

it‘s important to understand how and why. If you look at the composition of our portfolio in
your statement, you‘ll find that in Q4 we neither entered into any new positions nor exited any
existing positions. In other words, the decline did not come from trading in and out of stocks,
trying to ride the wild waves of an algorithm-driven market and getting washed up in the
process. We stayed steady and opportunistically increased our stakes in businesses that we have
owned, on average, for over three years. As such, our drawdown is but a function of the broader
market‘s meltdown in Q4.

It is a peculiar thing, that when the calendar flips on December 31st, society collectively decides
to tally up the scores and settle up. Phenomena like ―window dressing‖ and ―capturing tax losses‖
occur, which exacerbates the selling at the end of the year. This has not been the pattern before
2018 because every year from 2009 to 2017 has been positive, but the practice returned with a
vengeance last year as investors sold ―bad‖ stocks to erase their presence on year-end statements
while locking in losses with which to offset taxable capital gains. Sell orders overwhelm buy
orders and voilà, a negative feedback cycle is born4.

In theory, tax loss harvesting is a defensible strategy, but in practice, requires luck to pull off. If
we sell a stock for $80 which we bought for $100 to capture a $20 loss, we save $4 to $8
depending on your tax bracket. Meanwhile there‘s nothing fundamentally different besides the
fact that everyone was trying to jam through the exit at the same time. Often times, shares rally
back quickly, within the wash-sale window of 30 days – so often, in fact, that it has its own
Wikipedia entry: the January Effect. So if you sold at $80 to save $4 to $8 in taxes but it rallies
back to $100 within 30 days, you lost $12 to $16 net.

A far more reliable way to profit longer term is to take advantage of these phenomena by buying
securities we like at artificial discounts. I have no idea how cheap a stock will get, but I do know
when it‘s cheap. The cheaper it gets, the more I accumulate. This makes for ugly window
dressing come quarter end, but over time, we will more than make up for it as fundamentals
drive their intrinsic values ever higher.

While I make no predictions nor prognostications about the broader market, I am the most
bullish on our portfolio in years as evidenced by the amount of cash I‘ve put to work over the
past three months. And as of this writing, despite a decent rebound in price levels, it is still an
excellent time to invest more. Let me spend the rest of this letter explaining why.


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Table of Contents

Portfolio Review .............................................................................................................................. 4


General Motors .............................................................................................................................. 13

Regional Banks .............................................................................................................................. 16

Customers Bancorp .................................................................................................................... 16

CIT Group................................................................................................................................... 17

Telecoms ........................................................................................................................................18

Dish Network .............................................................................................................................18

Frontier Communications ......................................................................................................... 20

A Quick Tour Of A Few Others ...................................................................................................... 21

―Billy‖.......................................................................................................................................... 21

Heritage Insurance Holdings ..................................................................................................... 21

―Ricardo‖ ................................................................................................................................... 22

―Daphne‖ ................................................................................................................................... 22

Divestitures ................................................................................................................................... 23

Dillards ...................................................................................................................................... 23

Mistakes ........................................................................................................................................ 24

Atlas Financial ........................................................................................................................... 24

A Look Ahead ................................................................................................................................ 26

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Since mid-2014, BlackBerry (BB) has been our largest position. Given the importance of this
investment on our overall portfolio, it‘s appropriate to spend some time to rehash the history
and thesis for your analysis and judgment.

The rise and fall of BlackBerry, née Research In Motion, from 1984 to 2013 is well-chronicled:
Canadian engineering wunderkinds invent two-way pager capable of pushing e-mail over-the-
air, thus birthing the era of mobility. Wealth and fame follows, as does hubris, when they fail to
take seriously the dual threat of iPhones and Androids. Responses to threat are too late and are
botched, market share declines rapidly, last ditch efforts to regain glory ends in smoldering
rubble, and billions of dollars of shareholder value are vanquished.

Canadian insurance conglomerate Fairfax Financial enters the scene in late 2013, puts together
a consortium swapping a $1.25 billion life raft in exchange for convertible debt, and revamps the
directors and officers of the company. The keys to the kingdom were handed to then-58 year old
John Chen, who in his career has already turned around two publicly traded tech companies, the
most recent of which, Sybase, in the course of a dozen years, U-turned from a $400 million
market cap also-ran to a $5.6 billion SAP buyout.

Despite the fact that BB did not quantitatively fit the traditional ―value‖ model, I initiated our
investment on several key insights, originally outlined in 2016‘s annual letter and reproduced
here for convenience:

1. The unheralded money maker in most tech enterprises are high margin software services –
software is akin to the razorblade versus the hardware‘s razor. Despite being famous for the
BlackBerry smartphone, the company was actually reaping much fatter profits via the
monthly service access fees (SAF) they charge mobile carriers. Even when their fate in
hardware was doomed, the residual SAF continued to flow in, providing them a cushion for a
soft-landing. Notably, the technologies that powered SAF was software. Software that could
efficiently compress and encrypt network packets, software that provided cyber-security and
controls to IT departments that manage fleets of devices, software backed by significant
intellectual property, software that could be repurposed to support not just BlackBerries but
also iPhones and Androids. The sexy success of BlackBerry smartphones had diverted prior
management‘s attention away from the meat & potatoes of the business, but John Chen has
since refocused the company upon its true DNA: software.

2. Software alone is not sufficient for success, especially in the enterprise space. A platform
from which to market, distribute, sell, and support is arguably more important. It‘s one thing
for a whiz-hacker in a basement to write an app that goes viral; it‘s a whole different
ballgame when software is powering mission critical functions. A not-insignificant
investment must be made to build B2B awareness, a sales force, relationships with
thousands of channel partners, and a 24x7 support platform, a platform that has almost
nothing to do with technology itself but rather good old fashioned human resources and all
its foibles. BlackBerry, with its globally recognized brand, a reputation for security, and its
toehold in enterprises, had about half of that crucial platform already in place. Mr. Chen

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spent $800 million throughout 2014 and 2015 on acquisitions to fill out a complementary
portfolio of offerings and hired ex-Cisco executives to build out a world-class sales force and
channel partners ecosystem. Overall software revenues will likely exceed $800 million for
fiscal 2019, having grown from a mere $250 million in 2015, an accomplishment that is
backfilling the old vanishing SAF stream and buttressing the company as it invests in growth
for the future.

3. A mature, humming enterprise software company with a global sales and distribution reach
is extremely valuable. Software has no tangible cost, so every incremental subscription sold
is pure gross margin. Operating leverage is also significant, with industry operating margins
reaching the 30-40% range. There are also other favorable economics, such as getting to
bank annual subscription revenues upfront while recognizing them quarterly, reducing
taxable income while enjoying a deferred revenue ―float‖ with which to reinvest.
Furthermore, reinvestments in R&D and marketing are typically above-the-line expenses,
recognized immediately, further reducing taxable income to the benefit of higher future
revenues. In other words, true free cash flow is masked. As such, you will often see a sea of
red ink on the income statements of these companies despite ever-growing revenues; but
understand that they give a distorted view of the underlying economics which are actually
very advantageous. This is due to the conservative nature of GAAP (Generally Accepted
Accounting Principles) which has trouble interpreting the value of businesses whose
bedrocks are intangible assets.

I am, of course, hardly the first person to have these insights, which is why scaled up enterprise
software businesses are generally very pricy, sometimes trading at double-digit multiples of
revenues. It is very rare to buy into them at a decent valuation. BlackBerry‘s turnaround was an
opportunity to get in at the ground floor, at a sensible price, of a proven leadership team‘s ability
to build such a wonderful business.


In early 2018, BlackBerry‘s enterprise software segment decided to shifted their sales strategy by
completely eliminating the sale of perpetual licenses and offer only recurring subscription
licenses. This was done in conjunction with the so-called ASC 606 rule change whereby
companies are now required to recognize revenues ratably over the expected customer‘s lifecycle.
In plain English, it means perpetual license revenues now have to be chopped up and digested
over time.

The subscription model is the direction the software world is inexorably moving towards anyway
thanks to the increasing prevalence of high-speed internet. In the pre-broadband days, when a
company purchases software, they pay for a ―perpetual license‖, which is the enterprise
equivalent of, like, buying a shrink-wrapped box full of CDs from CompUSA. This license never
expires, but at the same time, it cannot be upgraded. For bug fixes and access to account
managers and technical support, etc., the enterprise has to pony up for recurring ―maintenance
support‖. For the software company, they get to recognize a big chunk of revenue up front from
the perpetual license sale, and then collect recurring maintenance fees. Every three or four years,
a new ―major version‖ will be released and the software company‘s sales force will come

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knocking to tout all the great, ground-breaking features in the new version. To incentivize the
enterprise to pay for a new perpetual license of the new version, the software company will at
the same time ―sunset‖ their maintenance program for the old version, leaving the enterprise at
risk of having to use old, buggy, unsupported software.

In contrast, a subscription model bundles software upgrades and maintenance support in one
recurring payment. The proliferation of broadband internet means enterprises can either
download the updates quickly or run the applications directly via the cloud. Subscriptions are
significantly cheaper than perpetual licenses and is thus generally a better deal for enterprises,
who get to spend less upfront while staying up-to-date without paying additional fees. For
software companies that transition towards such a model, their revenues will initially take a hit
as that large upfront shower of cash from a perpetual license sale goes away, but over the long
run, the recurring predictability of subscriptions and lower customer churn result in higher
customer lifetime values and lower commission expenses (e.g. your sales guy/gal won‘t have to
go knock on doors every couple of years to finagle new licenses from existing customers).

Although John Chen has pushed BlackBerry to be subscription-based from day one, the
company has nevertheless continued to offer perpetual licenses, with the split being at around
70%/30%. With the implementation of ASC 606, however, the benefit of large upfront perpetual
license fees are diluted – there‘s no longer any good reason for BlackBerry to not operate on a
100% subscription model. So in Q1, they ripped off the proverbial band-aid and discontinued
the practice of selling perpetual licenses altogether. This has caused their Enterprise Software
division to report declining revenues although the underlying customer base and billings rate
remained steady. Wall Street sell-side analysts, not known for being patient long-term investors,
downgraded the stock en masse.

Nonetheless, BB shares chopped up and down throughout most of 2018, mostly staying above
2017‘s year-end level until Q4‘s dramatic market rout. BB fell from $11.17 to $7.11 in 2018, with
all of the decline occurring in Q4. What had been an, in my opinion, fairly valued stock at the
end of 2017 once again became a superior bargain by the end of 2018. We lowered our cost basis
by adding back the shares we sold in 2017, and if it were not for the fact that it is already a full
position and other bargains were rapidly presenting themselves in December, I would have
bought even more.

At the nadir on Christmas Eve as Mr. Market was losing its mind in the vortex of tax-loss selling,
BB was changing hands for as low as $6.57 per share, implying an Enterprise Value (EV) of less
than $2 billion5. From a strategic acquirer‘s perspective, any of BlackBerry‘s three business
segments (Enterprise Software & Services, BlackBerry Technology Solutions, Licensing & IP) is
likely worth more than $2 billion each if they are willing sellers today.

1.) Enterprise Software & Services: Currently their largest and most mature segment, doing
close to $400 million in revenues per annum. This is an amalgamation of their original BES
product that manages cell phone fleets and a series of acquisitions made in 2015 that
includes mobile app containerization, file sync & share, mass alert & communication, etc.

Excluding the effect of the $1.4 billion Cylance acquisition, which has yet to close as of this writing.

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They are dominant in highly regulated industries like government, finance, and legal where a
certain level of security is legally mandated. Although organic growth has slowed recently,
their customers are fairly sticky as it is imprudent to switch to other software providers who
do not have the same security pedigree and certifications as BlackBerry. Further growth will
come mainly via acquisitions, one of which, Cylance, is currently undergoing the regulatory
approval process and should provide a substantial ~$200 million boost to the top line in the
next fiscal year. More on Cylance later.

2.) BlackBerry Technology Solutions: BTS represents BlackBerry‘s most immediately visible
growth over the next five years, chiefly via their QNX product. QNX is a real-time operating
system (OS) designed to run on a very small footprint in very important, ultra-high
availability projects (think nuclear reactors and such). QNX was acquired by BlackBerry in
2010 from Harman, a company that specialized in automotive audio and visual products, i.e.
the infotainment dash in your car. Under Harman‘s ownership, QNX quietly went into the
backbone of nearly all automaker OEMs and today is in 120 million automobiles, a market
share north of 50%.

An operating system is notoriously complex and is easily the most important piece of
software in any semiconductor-powered device. It acts as the frame, plumbing, and electrical
infrastructure of a computer. A good OS provides safety and stability to everything built on
top, and does so efficiently. As such, OS‘s are not trivial apps that are easily competed away.
Once they are established and accepted, they are very difficult to dislodge, and network
effects apply – the more widespread an OS, the more apps are written for it, which begets
further adoption. In the history of computing, there have been only a handful of major OS‘s
such as Unix, Linux, and Windows.

QNX itself is a derivative of Unix and has been around since the ‗80s. BlackBerry is
leveraging its established footprint in the automotive supply chain to push QNX into the new
frontier: advanced auto technologies. The car of tomorrow will have advanced driver assist,
over-the-air software updates, fully digital instrumentation, 5G communication with both
―smart‖ infrastructure (V2X) and other active vehicles (V2V), and many more innovations
that will revolutionize the driving experience. QNX will likely underpin much of that.

BlackBerry has secured design wins with a variety of Tier-1 suppliers such as Bosch, Aptiv
(f.k.a. Delphi), Denso, and Magna, as well as with tech giants like Qualcomm, NVIDIA, and
Baidu. All of these relationships represent potential, but it will take time to convert these
into royalties as they make their way into future car models. Royalty revenues are only now
starting to flow in from designs won back in 2015. It‘s an extended gestation period, but the
revenue tail is long and stable and has 90%+ gross margins.

Automotive is but just one industry in which QNX holds potential. Adjacent is the trucking
and shipping industry, where BlackBerry has launched Radar, a lightweight scanner about
the size of a gold bar that, when affixed onto a container door, transmits real-time info into
the cloud regarding cargo location, temperature, pressure, humidity, etc. The core of Radar‘s
technology is QNX and all the IP that served the company‘s smartphone producing days. Its

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true importance lies not in its potential sales, but as a proof-of-concept for what QNX can do
to accelerate innovation in ―smart‖ devices in any industry.

From a broader strategic perspective, BTS aims to enable the proliferation of IoT (Internet of
Things) devices with software that is lightweight, secure, and born in the cloud. The idea
here is ―digitalizing the physical space‖ – whereby in most of human history, time passes by
and 99.999% is forgotten, now more and more of the world can be captured, measured,
studied, and improved upon as storage and bandwidth and processing power continue to
scale exponentially6. The R&D behind this revolution has eclipsed a tipping point – industry-
wide, too many billions have been poured into this effort with untold billions more to come.
BTS stands a good chance to grab a slice of this gigantic pie, of which even the thinnest could
multiply their current annual revenues many-fold.

3.) Licensing & IP: Over the past five years, this segment has grown from a standing start to
approaching $200 million in recurring annual revenues. The asset base is a cache of
37,000+ patents they‘ve accumulated throughout their history, many of them critical to
modern smartphones and networks. The precedence for optimism here are Nokia and
Ericsson, both of which used to have significant mobile phone manufacturing business but
have since divested them while continuing to profit from their Intellectual Property.

Furthermore, BlackBerry as a smartphone brand continues to thrive in niches, especially for

folks who prefer typing on physical keys to glass slabs. The brand has been ―franchised‖ to
TCL as BlackBerry Mobile, and their KEYone and KEY2 family of phones are full-fledged,
modern Android smartphones with wonderfully clicky keys for your thumbs and a hardened
OS kernel that monitors/blocks apps that tries to access phone functions it shouldn‘t. The
days of this being a rainmaker are long gone, but the marginal revenue stream from royalties
here are pure profit with no risk of losses.

While Enterprise Software was a slight drag on overall GAAP revenues, both BTS and Licensing
& IP have grown in excess of 20%. BTS in particular gives us good reason for bullishness, as
QNX design wins with auto OEMs and suppliers continue to roll in, representing a significant
backlog of high probability royalties that should continue to power double-digit growth for years
to come.


In my Q3 letter, I alluded to a silver lining on the tech sector sell-off. BlackBerry had been
seeking a large, transformative acquisition for several years to boost their maturing Enterprise
Software segment but was put off by the high asking prices, often veering well above 10x sales of
an albeit rapidly growing company. A sell-off, then, is akin to a discount sale for would-be
buyers. In November, they agreed to acquire Cylance for $1.4 billion at a price that is likely to be
~7x sales at the time of closing.

E.g.: Your health, now being measured by your Apple Watch. Containers, being more efficiently utilized. Railroads,
every yard being constantly monitored for hazards. Warehouses, inventory being automatically reordered and

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Cylance sells so-called next generation Endpoint Protection Platforms, or, in layman‘s terms:
Super Smart Anti-Virus. Whereas traditional anti-virus software rely on ―signature‖ databases
that must match known malware down to the byte, Cylance‘s products use Machine Learning to
detect suspicious files and activities 7 . So instead of relying on humans to update signature
databases regularly from reported infections, machine learning algorithms protect you even if a
virus is brand new and never before seen. Further, reliance on algorithms rather than brute-
force databases significantly lowers the processor and bandwidth requirements of the protectee.
This is vital for new, IoT devices that have never before been connected but are now a ―threat
vector‖ that enables, e.g. Russian bots, a path to burrow into critical systems.

Anyway, it‘s pretty cool tech, and it should provide an immediate jolt into BlackBerry‘s
Enterprise Software offerings and further burnish their security-focused brand. In the longer
run, Cylance products will make their way into QNX software stacks that protect connected
vehicles from being hacked. This is a significant item of differentiation with their fellow super
smart anti-virus competitors, who are all essentially PC/Mac-only at this point.

This deal is not a slam-dunk, however, because even at a reduced ~7x sales price tag, I estimate
Cylance would have to drive revenues and/or synergies of ~$400 million (double their current
annual sales) over a reasonable period of time to make this a good bargain. This is not only the
largest acquisition of John Chen‘s career, it is also the priciest, and thus requires adept
execution to be worthwhile. His track record suggest success is probable.

The good thing is at our cost basis in the ~$7 range, we‘re getting the potential upside for free.
Even if the Cylance acquisition ends up a total bust, the value of BlackBerry‘s other segments
will still generate nearly $1 billion in revenues in fiscal 2020 against an EV (at year-end, pro-
forma for Cylance) of less than $3.5 billion. A 3.5x EV/sales multiple is more commonly
reserved for sub-scale software companies with unclear growth prospects, but as I‘ve detailed
with QNX above, this is decidedly not the case for BlackBerry. Operationally, the company has
turned a significant corner and is now generating consistent and recurring free cash flows,
which should (ex M&A costs) run-rate at about $160 million per annum with de minimis
contribution from legacy SAF. The long and arduous turnaround is definitively complete, and
going forward, we should finally start to see year-over-year improvements on the top and
bottom line on a company-wide basis for the first time since fiscal 2011.


This is company Kool-Aid but it’s actually a pretty good primer and sans too much breathless marketing hype:

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General Motors

Our second largest position, General Motors (GM), was also initiated in 2014, shortly after
their ignition-switch scandal broke. At the time, it was feared GM would not only have to pay
billions in fines and lawsuits, they would, worst of all, suffer a permanent tarnishing of their
brand. However, CEO Mary Barra expertly guided the company through this tough stretch,
setting up a settlement fund headed by independent administrator which paid out almost $600
million in reparation. More impressively, she owned up to the mistakes made, testifying as such
in front of Congress and took the political beating on the chin. Contrary to the ―moving on‖
rhetoric most people take when confronted with scandal, she exhorted the company to ―never
forget‖ instead. I believe there is a genuine cultural transformation going on at GM that, in
parallel with their post-2009 bankruptcy financial transformation, is creating a corporation that
is differentiated from both their complacent past as well as their Detroit peers.

As mentioned in prior annual letters, our position in GM is expressed via its ―B‖ warrants, which
you‘ll see on your statement as ―GM WS B‖. The warrants are freely traded on the New York
Stock Exchange with a strike to purchase GM common for $18.33 per share expiring on July
20198. The warrants, which, given that shares are trading significantly above the strike, act as de
facto leverage9, allowing us to increase our exposure without spending more cash10. Our 8%
position roughly represents a synthetic 16% position in the common, which is why I coin it our
second largest position despite it not appearing so on our statement – a constant mental
reminder that I am applying leverage here.

GM declined from $40.99 to $33.45 in 2018, an -18.39% drop as the stock fought an unrelenting
wave of pessimism ranging from the Trump Administration‘s tariffs on steel and aluminum to
the Trump Administration‘s cold war with China to fears of a U.S. recession to rising interest
rates impacting automobile affordability to on-going struggles at Ford, etc. And yet the company
managed to nearly match 2017‘s record per-share profit in 2018 ($6.62 vs. $6.54) despite
initially pulling down guidance to $6/share earlier in the year as the effect of tariffs were
dramatically raising raw material costs. In October, I raised our stake by a third, when shares
were trading for less than 5x P/E.

We can break GM‘s value into three primary prongs: Their 1.) truck franchise, 2.) finance arm,
and 3.) Cruise automation. While the U.S. passenger auto market has plateaued at around 17
million per annum, it is experiencing a structural ―mix shift‖, where the mix of sales is shifting

The warrant was issued as part of their restructuring in 2009.
In derivative parlance, its Delta is very nearly 1.0, i.e. for every $1 that the common moves (up or down), the
warrant moves $1 x 1.0 = $1. Meaning if GM common goes from, say, $40 to $41, the warrant’s intrinsic value
goes from $21.67 to $22.67. We are exposed to the equivalent $1 move but we only need to spend $21.67 per
share rather than $40 per share.
The flip-side is that the warrants do not pay cash dividends. It is my judgment that the liquidity we gain to buffer
us in the event of further shocks against the cost of missing some quarterly dividends is worth the trade-off.

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towards the bread and butter of GM: trucks11, SUVs, and cross-overs, where brand loyalty is
strong and margins are high12. Indeed, according to Edmunds, trucks & SUVs are supplanting
luxury cars, with brand loyalty at all-time highs in the former and at all-time lows in the latter13.
North American sales, powered mostly by trucks, SUVs, and cross-overs, account for the
majority of GM‘s current annual automotive earnings of ~$8 billion.

GM Finance (GMF) is their so-called captive lender, an institution which provides loans, leases,
insurance, and extended warranties to folks who buy from GM dealerships. Captive lenders
enable promotions such as 0% financing and flexible terms that traditional banks generally
won‘t offer. Essentially, they grease the wheels of the sale, cutting out third-party lenders that
gum up the process. GMF is the fruit of the acquisition of AmeriCredit back in 2010, when they
exited bankruptcy and had to re-build their captive lending arm14. Since then, they have grown
assets to $97 billion and generated $1.6 billion in net income last year. Even if we conservatively
value GMF by just its tangible book value, that still amounts to $8.7 billion.

In 2016, GM bought Silicon Valley startup Cruise Automation for $1 billion, a deal which I
thought at the time they far overpaid for essentially 40 employees and its code base. Since then,
they have scaled up to over 1,000 employees, including having lured some of the most in-
demand talent15, and attracted a $2.25 billion investment from Softbank and a $2.8 billion
commitment from Honda. Notably, of Honda‘s $2.8 billion, $750 million was invested up-front
for only a 5.7% stake, implying a valuation of over $13 billion.

It‘s difficult to say which is more astonishing, the fact that Cruise‘s value went from $1 billion to
$13 billion in two years, or that GM‘s market cap went from ~$48 billion at the time of the
acquisition to ~$47 billion at 2018 year end (after the Honda investment). The math implies
either the market thinks both Softbank (who knows a thing or two about tech) and Honda (who
knows a thing or two about cars) vaporized their money on something worthless, or GM‘s core
businesses have destroyed billions in value since 2016. The latter is provably untrue based on
any financial metric you choose to look at. The former is almost certainly untrue given the
industry trends, the due diligence of their sophisticated investors, and the viability of self-

Ironically, a 25% tariff has been in place since 1964 to protect U.S. pick-up trucks from international competitors
This captive lending innovation was actually invented by GM in 1919, then known as GMAC. During the ‘80s and
‘90s, they began to glom together other financing businesses… such as mortgages. Said mortgages eventually
took down GMAC during the financial crisis, and GM sold down its stake before falling into bankruptcy anyway.
GMAC eventually took government money to stay afloat and rebranded themselves as Ally Financial, now
independently traded as ALLY on the NYSE.

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driving technology itself in a vacuum16. Ergo, I think the odds are tremendously good that GM is
still meaningfully undervalued.

Why GM‘s shares continue to trade at such a depressed valuation will make for an interesting
Harvard Business School case study in the future. Bear arguments rely on a view firmly rooted
in past. Detroit‘s auto giants have traditionally experienced extreme boom-bust cycles. During
good times, they crank and crank and, due to the lag time of manufacturing complex machinery
and an inflexible union workforce, inevitably overshoot demand, which lead to bad times of new
cars sitting unsold on lots and used cars coming off leases, a terrible glut that requires deep
discounts to clear which compresses margins down to zero or worse. The classic theory is that,
as such, they deserve low P/Es during the peak and high P/Es during the trough17.

So prevalent is this bear case that it is brought up nearly every quarter during their conference
calls. And despite management‘s repeated reassurance that, yes, they are well aware of this
phenomenon and they are taking steps such as tightening up supply chain inefficiencies and
drastically cutting back on low-margin sales to rental car companies and furloughing part-time
workers and idling plants that make slow-selling sedans and putting policies in place to not
extend irresponsible financing just to make their monthly sales numbers but to focus instead on
building brand loyalty, there appears to be just no assuaging the bears.

My differentiated and contrarian view boils down to a simple thesis: do you believe the
structural cyclicality of this industry is a permanent, unavoidable phenomenon, or are there
discrete steps that can be taken to lessen, if not eliminate, the pain of the cycle? And if yes to the
latter, is this management team capable of executing? I say yes. And I believe their continued
delivery of outstanding operating results in the face of macro and political headwinds while their
peers struggle, plus their deft capital allocation decisions in selling their European brands and
investing early and smartly in Cruise Automation and now making large scale workforce
restructurings while times are still good are emphatic proof points in our favor18.

Here, I can also point to precedence  Toyota Motors is the sterling, best-in-class operator
which has experienced a consistency in sales and profits extending through multiple cycles. GM
is not Toyota—not yet—but they have the right assets in place with the right management team
espousing the right ideas that is right-sizing the culture. A steady EPS combined with stock
buybacks at a sub-10x P/E valuation with the potential of an expanding multiple as they slowly
march towards Toyota-esque efficiency and the home-run of a potential Cruise IPO should
continue to provide us a highly satisfactory result over time.


Here’s a cool dash cam video of a Cruise vehicle going through some of the more tricky San Francisco streets:

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Regional Banks

Our accumulation activity in Q4 was especially concentrated in our bank holding companies,
where I‘ve roughly doubled our existing stakes. As I wrote in November, financials experienced
indiscriminate selling due to fears of continued interest rate increases by the Federal Reserve
and a looming recession. Shares of some banks plunged below tangible book value – which
implies either severe crisis-level credit losses ahead, or something structurally broken with their
earnings power. Neither is currently true, and in my estimation, neither is remotely likely. I am
not the only one with this opinion19.

Let‘s start with Customers Bancorp (CUBI), which declined from $25.99 to $18.20 in 2018.
Customers is a regional business bank serving the northeast corridor from D.C. to Boston that
eschews brick-and-mortar branches. Instead, their banking teams travel to clients to conduct
business and have deep roots within each local community. The benefits of this ―concierge‖
model are multiple. Customers has much lower fixed costs and much higher productivity per
employee than the typical bank. Lower fixed costs give them the leeway to generate good ROEs
(10-12%) without reaching for higher-yielding risky loans (non-performing loans were a
miniscule 0.32% of assets compared to industry averages of around 1%).

CEO Jay Sidhu founded Customers during the Great Recession a few years after he was pushed
out of Sovereign Bancorp, an institution he grew from a tiny thrift into a $89 billion asset
powerhouse. His ignominious exit came at the hands of a disgruntled activist in 2006, and since
then he‘s had a proverbial ―chip on the shoulder‖, incentivized to reclaim a legacy as a successful
banking executive. He set up shop in the same city where he built his previous empire and
rallied his old Sovereign management team back together. By 2017, eight years after taking
control of the erstwhile New Century Bank and rechristening it Customers Bancorp, they had
grown assets from $350 million to just shy of $10 billion.

However, since 2015, they have been hobbled by a subsidiary called BankMobile, a digital bank
venture targeting millennials started by Mr. Sidhu‘s daughter, Luvleen. Nevermind the nepotism
for now, BankMobile has become a metaphorical albatross around Customers Bancorp‘s neck,
not only having posted losses for three consecutive years, but also having absorbed excessive
amounts of management‘s attention during its attempted sale in 2017, then its attempted spin-
off in 2018, only for both to end in failure. Most damningly, it has forced the bank to cap its total
assets below $10 billion lest they trigger a law in the Durbin Amendment that would limit the
amount BankMobile can charge for debit card interchange fees, which would have further
widened its net loss. The $10 billion asset cap has been so costly because, ex-BankMobile, the
core bank itself is as healthy as it ever was, gathering deposits and making good loans and
remaining well capitalized and generating ROEs above 10%.

Beyond the basic lost opportunity of compounding retained earnings, there were also capital
allocation blunders and loss of focus on the basics of managing a publicly traded bank. After the
BankMobile spin-off fell apart in Q3, securities had to be sold for significant losses to ensure


P a g e | 17

they stay below the $10 billion asset mark. And then there was an episode where management
was forced to revise a whole year‘s worth of financial reports because they mistakenly
categorized certain activities as Cash Flows from Operations when it should be Cash Flows from
Investing. This had no material impact on their overall economics but the optics of having to re-
file with the SEC and admit to weakness in internal controls is unattractive to say the least (and
may have cost the CFO his job20). Meanwhile, CEO Jay Sidhu continues to put up a forceful
defense of BankMobile, and one cannot help but wonder how much of his judgment is biased by
the fact that it‘s his daughter‘s startup.

And yet… I increased CUBI from a minor 3% position at the end of 2017 to a 9% position by the
end of 2018. To a value investor, there are no bad assets, only bad prices. At year end, CUBI‘s
Tangible Book Value (TBV) had climbed to $23.32 per share while its stock fell into the $18s.
Despite all the hullabaloo caused by BankMobile, CUBI still earned $1.78/share in 2018. Most
importantly, its core business bank earned $2.19/share, and would have been $2.75/share were
it not for having to sell those securities at a loss. So at a minimum, even capping their balance
sheet at $10 billion, if BankMobile managed to just break even (something management is
pledging to achieve by Q4 this year), CUBI has an implied earnings power of $2.75/share which
at year-end implied a valuation of less than 7x P/E and 0.8x P/TBV. That is a good deal.

And so we remain shareholders, living with the understanding that Jay Sidhu, while a talented
and accomplished banker, has a tendency to take oddball risks that can shed value at the
margins. As such, I will be nimbler with this position than others, quicker to take profits when it
reaches a fair value range.


On a happier note, our other bank holding company, CIT Group (CIT), proceeded drama free
in 2018 yet again. While its stock declined from $49.23 to $38.27, its earnings per share actually
increased from $3.39 to $3.94, including a fairly clean Q4 print of $1.21 implying a run-rate
earnings power of $4.80. This will likely increase again this year.

CIT is a middle-market bank that has transformed from a hodge-podge collection of global
lending businesses overly reliant on funding from high-cost capital markets into a legitimate
mid-sized commercial bank focused on the United States with a growing low-cost deposit base.
Its transformation has been a multi-year affair, emerging from bankruptcy in 2009 and led by
ex-Merrill Lynch CEO John Thain who, as his final stroke, acquired OneWest bank in 2014 and
promptly retired, handing the reins to current CEO Ellen Alemany.

The OneWest acquisition has been, with hindsight, a good one, because it vastly expanded CIT‘s
deposit base, but it came with a host of headaches. OneWest was itself a turnaround project built
from the pieces of infamous subprime mortgage lender IndyMac. CIT took hundreds of millions
of charge-offs related to soured loans, specifically in the reverse mortgage business. In 2018,
they divested what was left of their reverse mortgage loan book, sold off their European rail
leasing business for $1.2 billion, and terminated their high cost wholesale borrowings.


P a g e | 18

Ms. Alemany and her management team have proven to be impressive operators, methodically
unloading extraneous pieces of the business for good prices, excising the damage from the
OneWest acquisition, getting back on the bank regulators‘ good side, using the proceeds to buy
back $5 billion in common stock, lowering funding costs, and studiously marching CIT back
towards a 10+% ROE earnings power. The end result is a much slimmer company more focused
on their historic niche in the middle-market with a dramatically improved funding structure.

With year-end tangible book value at $51.15 per share and run-rate earnings at $4.80/share, it
made no sense for the stock to trade as low as $35.50 in December. I doubled our stake in CIT in
Q4 at an average cost ~$39/share, which should comfortably pay off in the double-digits over
the next several years.


The single position I augmented the most in our portfolio in 2018 was Dish Network (DISH),
which was increased from a 3% to an 8-9% position over the course of the year. The company
has had a rough go of things since 2015, with their stock steadily falling from the $70s in 2015
down to the $24.97 at year-end 2018. Dish‘s current business is their declining Direct Broadcast
Satellite (DBS) service, i.e. satellite TV, as well as a small but growing IP TV service called Sling.
But what we‘re really buying is 95 Mhz of nationwide wireless spectrum that their founder
Charlie Ergen has slowly amassed over the past decade that is un-deployed, and is either
extraordinarily valuable (bull) or is nothing but a bluff and deserves to be confiscated by the
FCC (bear), depending on who you ask.

Prior to 2017, most analysts speculated that Mr. Ergen‘s purpose in hoarding this cache is to flip
it to AT&T or Verizon for a profit or merge with T-Mobile or Sprint to immediately own a
network and customer base that can tap the spectrum, but it‘s now apparent that short of a
Godfather offer, his intent is to build a real, brand new business around it. Many owners of
DISH who hoped for a quick payday have sold their shares in disappointment, hence its brutal
decline. We, on the contrary, have been in it since day one because I want us to partner with Mr.
Ergen who, as the company‘s founder and majority shareholder, plays a long game. With much
of the speculative froth blown off and, I‘d argue, unwarranted pessimism baked in, DISH has
become increasingly attractive, and at our cost basis of ~$35/share, we own it at ~10x free cash
flows of its pay-TV business with the huge spectrum option thrown in for free.

There is no shortage of bad news on the pay-TV front, however. Cord-cutting is an accelerating
trend as Americans are increasingly excising their $100/month TV bill in favor of a la carte
selection of Netflix, Hulu, Amazon Prime, YouTube, et. al. To make things worse, content
owners and local broadcasters who bundle channels into pay TV packages continue to demand
price increases to offset the lost revenues from cord-cutting. A vicious cycle is in force: price
increases that accelerate consumer abandonment lead to more price increases. Pay TV providers
like Dish are caught in the middle, at once being blamed by consumers who hate big monthly
satellite/cable bills jammed full of channels no one watches, while also being punished by
content owners who black out channels if they refuse price increases and who are also
experimenting with their own direct-to-consumer over-the-top (OTT) offerings.

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Economics 101 tell us this is not sustainable. Everyone in the telecom/media ecosystem is now
in a knife fight with each other, trying to have their cake (by milking the traditional pay TV
bundle) and eat it too (by launching their own OTT streaming services). The problem is no one
is going to pay 15 different a la carte monthly subscriptions for $5-10/month. The instigator that
crashed the party and started this chaos is Netflix who, by the way, brought a gun into this fight
as the stock market rewards them on pure growth and ignores their negative cash flows while
most everyone else has to manage their quarterly EPS and actually generate cash and pay
dividends21. A new business model will have to emerge because everyone is starting to lose

Dish‘s strategy in this mayhem is K.I.S.S. (keep it simple, stupid). Don‘t compete in content, stay
specialized in distribution. Focus solely on doing the best job at the lowest cost they can. Ignore
Wall Street‘s obsession with gross subscriber numbers and concentrate instead on customer
lifetime value. Attract and retain the subscribers who are more rural and thus do not have
multiple options or have limited broadband. Emphasize margins – be willing to lose subscribers
who are just there for promotional deals. Be willing to resist higher and higher prices demanded
by content owners especially if it means dropping channels that few people watch anyway or
have other options to access (via OTT or even a plain old antenna). Explore ancillary revenue
opportunities ranging from expanding home service installations to digital programmatic
addressable advertising.

In short, manage the DBS and Sling business to generate cash. Total subscribers declined 6.9%
year-over-year, but adjusted EBITDA only declined 2.5%. Average monthly churn remained at
1.78% despite losing both Univision in the summer and HBO in the winter over fee increase
disputes. Operating cash flows stayed steady. From 2014 to 2018, it has totaled (in billions):
$2.38, $2.44, $2.80, $2.78, and $2.52. This is cash that is paying off the debt incurred to lease
the spectrum. Cash that will be used to erect the beginnings of a new, pure-play 5G network.

The thing that matters most for Dish is bridging over to 2020 when the 5G standard will fully be
ready22. It will cost $10 billion, Mr. Ergen has already admitted, but there will be new partners
and there will be new capital. What form those will take is unknown, but the permutations are
myriad, as interest in 5G connectivity spans not just the traditional telecom providers, but all the
tech behemoths as well. That will be a catalyst.

What is 5G, exactly? Perhaps it‘s worth a paragraph to ponder. The primary hype is higher speed
(download a 4K movie onto your phone in 3 seconds!), but more importantly, it‘s low latency,
low energy, and massive connectivity. It‘s many more devices communicating more frequently
with almost no lag. 5G will be the critical plumbing to enable smart cars, smart cities, for big
data to be available everywhere, for artificial intelligence to be distributed and refined
exponentially, for ―digitalizing the physical world‖.

But life is unfair, and in my opinion, all the credit goes to Reed Hastings and Netflix for pulling this off.
Lots of marketing spin, e.g. AT&T branding their upgraded 4G as 5G-Evolution, but true 5G standards have yet to
be fully codified and accepted. This will happen first with 3GPP Release 15 in April 2019, then Release 16 in April

P a g e | 20

To be fair, those that doubt Dish are not unreasonable. It is an admittedly huge task and there
are deep-pocketed competitors. Meanwhile, the challenges in their legacy TV business are severe,
where the biggest, baddest rival can afford to be economically irrational. But DISH at $25/share
is pricing in the certainty of total failure. It appears to neglect Dish‘s resilient history – its
previous transformation from analog C-band satellite TV (a.k.a. big ugly dishes) to digital direct
broadcast satellite in the mid 1990‘s. The parallels are striking, with Dish (née EchoStar)
winning spectrum and seeking out capital and building out infrastructure and then trekking all
the way to Sichuan, China to launch their first satellite23, all without a penny of accompanying
revenues. But they did it! It wasn‘t a bluff. And their stock was a 10-bagger within 5 years.

Charlie Ergen will go down in history as one of America‘s great entrepreneurs, and I am always
happy when there‘s an opportunity to ride his coat-tails at a discount (see: SATS in 2013). If Mr.
Ergen‘s 5G magnum opus comes to fruition, we will all enjoy a magnificent bonanza. But if not,
at our cost basis, we are unlikely to lose very much24.

Our other addition in the telecom space was Frontier Communications (FTR), a top four
so-called ILEC (Incumbant Local Exchange Carrier) telephone company in the United States.
We actually traded FTR for small gains briefly back in 2013, but then stayed away when the its
risk/reward took dramatic turns for the worse as the company, in their ambition to get to such
an exalted size, loaded up on expensive debt to buy legacy wireline assets from Verizon in
California, Texas, and Forida in 2015. It was literally all downhill from there, as the stock went
from a high of ~$125/share down to $2.38 at year-end 2018.

To be blunt: Frontier is in distress. Their aggressive M&A strategy has left them over-levered
and under-invested in operational efficiency, and with well-run competitive sharks like Comcast
and Charter passing cable through their territories, they have been losing subscribers at an
unsustainable clip. Nevertheless, their stock in the single digits represents a rare special
situations call option: at our cost basis, we own FTR at a mind-boggling 1x P/FCF. Of course, it
is a meaningless figure if, by 2021, they cannot refinance $1.6 billion of debt that is due and is
forced into Chapter 11 bankruptcy, which is a very real possibility. For that reason I have hard-
capped our exposure at 2% of capital.

Despite their struggles, they still generate enough EBITDA to cover cash interest payments twice
over. They are FCF positive, eliminated their preferred stock, and completely cut their dividend.
And luckily, they have one asset that is indispensible in today‘s world: DSL / FiOS broadband
internet service. There‘s a chance they can stabilize their subscriber base on that alone if they
stay focused on repairing their operational shortcomings. If FTR pulls off a refinance of their
2021 and 2022 debt maturities, I believe we‘re looking at a potential 1x down, 10x up
risk/reward ratio in their common stock.

Notably, Charlie Ergen bought 100,000 shares for $2.94 million in May 2018 on the open market. At the same
time, his co-founder, Jim DeFranco, began buying 5,000 and 10,000 increments and have since hauled in a
whopping 375,000 shares (and counting) ranging from $25 to $35 per share.

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A Quick Tour Of A Few Others

 “Billy”, the Canadian alternative energy power producer I first talked about in my 2014
investor letter25, remains a staple in our fund as it has been since our inception. Nothing has
changed with the core thesis. Wind keeps blowing and water keeps running and their cash
keeps flowing. Its stock, however, broke its streak of six straight years of double digit gains
due to several reasons: 1.) They‘ve reached a size where moving the needle becomes more
difficult than just throwing up a big wind farm each year, 2.) Government subsidies such as
Feed-in Tariffs, which they rely on for revenues, are facing a populist backlash, which, while
it will most likely not impact their established Power Purchase Agreements (PPAs), could
make reinvesting capital more difficult, and 3.) France, where they have a large presence,
has been experiencing lower-than-usual wind flow.

None of these issues are deal breakers. Slower growth after a certain size is expected and will
eventually be accompanied by higher dividends. And uncertain political winds (and
geostrophic winds) are normal short-term fluctuations that, should they continue, can be
mitigated by management. 2018 was the first significant decline in its shares in six years,
and as such, the first time I was able to increase our position a bit at attractive valuations.

An interesting n.b. is that their long-time CFO retired in December and was replaced by a
fellow who previously directed private equity investments for Canada‘s second largest public
pension fund… the same exact fund that acquired a 17.3% equity interest in ―Billy‖ back in
2017. With the dramatically increased firepower of their new equity partner and a new
finance chief that hails from said pension fund, ―Billy‖ is well equipped to become a much
bigger player in the energy space, and I would not be surprised if this eventually leads to a
complete buyout by the pension sometime down the line.

 Heritage Insurance Holdings (HRTG), a property catastrophe insurer based in Florida,

had a relatively uneventful 2018 compared to the Hurricane Irma fireworks of 2017 when we
were able to scoop up shares below $10, a 30+% discount to book value. The majority of
2018 was spent digesting NBIC, a large acquisition which diversified their business 50/50
outside of Florida in one fell swoop, and steadily exiting the Florida Tri-County area (Miami-
Dade, Palm Beach, and Broward), where the so-called Assignment Of Benefits insurance
fraud26 has been rampant. This holding impacted our overall results by around -1% for the
year, but more importantly, qualified for long-term capital gains status in Q4.

Which I will continue to demure from revealing for now due to… political reasons. Call me if you want to know.
An “AOB” is when homeowners sign over their insurance policy rights to contractors/lawyers who then file
inflated claims against insurance companies. Loopholes in Florida state law such as loose restrictions in allowing
the claimant to recover attorney fees have proven hard to close legislatively due to, obviously, intense lobbying
from the lawyers benefiting from them:

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Tax savings reasons aside, we continue to own HRTG because I consider the regional
catastrophe insurance space to be inefficient, more prone to market hysteria whenever
hurricanes threaten Florida, and therefore a discernable edge exists for someone like myself
who has followed this industry for years. However, Heritage does not enjoy a terrifically wide
moat with regards to underwriting and thus it does not deserve as big a position in our
portfolio. Catastrophe insurance is a well-trodden line of business with competitors who all
use the same handful of vendors that model natural disasters and the same array of
reinsurers backing them up. Nevertheless, as they continue to integrate and realize
reinsurance synergies from their NBIC acquisition, there should be a long runway for growth
and opportunities for us to trade around the position during hurricane season.

 “Ricardo”, a pinksheet microcap who shall remain unnamed for the duration of our
holding due to its small and illiquid float, is a value-added reseller (VAR) of a Fortune 500
software company – i.e. they are a wholesaler of their products. Companies like ―Ricardo‖
play an integral part in distributing and supporting enterprise software, enabling their
vendors to reach niche customers, be it geographic or industry-specific, they otherwise
wouldn‘t be able to. ―Ricardo‖ recapitalized in 2014, with majority control being taken by the
family trust of a wealthy activist with a long and sterling track record of value creation. The
company has since simplified their business and redirected most of its excess cash flows to
debt reduction. ―Ricardo‖ began as a Special Situations investment as I had anticipated
another recapitalization once its debt was sufficiently reduced to completely buy out
minority shareholders such as ourselves. However, in 2017, they began acquiring other VARs
instead, a roll-up strategy that will require operational discipline to be value accretive but
can be the start of a lucrative, multi-decade exercise in compounding a la Constellation
Software. Early indications are promising, but more time is needed to see if they will be able
to successfully pull this off.

 “Daphne” is a Canadian microcap, also too small and illiquid to be revealed throughout the
extent of our involvement. They are a B2B provider offering Canadian businesses document
and marketing print services. This is not a growth business, frankly, but there is ample
precedence of producing solid shareholder returns in a no-growth arena, especially when our
purchase price was 4x free cash flow. Still, this is without question a high risk investment, a
distressed situation where management is racing to consolidate warehouses while buying
and integrating niche companies with sustainable business models to replace their own. It
was, ironically, one of our biggest winners percentage-wise in 2018, rising 19.8%, with
impressive year-over-year gains made in revenues, gross margins, and EBITDA. Although its
small size in our portfolio made its contribution negligible overall, the market has yet to fully
acknowledge ―Daphne‖ for their turnaround. If they continue their momentum over the next
year or two, it could eventually reward us with a needle moving 3-4x return.

P a g e | 23


We had only one major divestiture in 2018 which I wrote about in my Q2 letter: Dillards
(DDS), which we sold for ~$77/share in May, a 70%+ total return in almost exactly one year.
The excerpt is reproduced here for your convenience:

Looking back, from October 2016 through October 2017, how went Amazon, so went the inverse
of retail stocks:

Candlesticks: Retail ETF / Orange line: AMZN – Oct 2016 to Oct 2017

Amazon, of course, deserves its accolades. Retail, though, does not uniformly deserve their
obituaries. By Q4 2017, it became clear the retail survivors‘ retrenchment was effective and
shares across the board rallied. And DDS, by virtue of their low 4x FCF valuation and their
extremely aggressive buyback (100% funded via free cash flows), was able to amply buoy their
per share earnings. Far from requiring otherworldly analytical skills or insights, all one really
had to estimate was a (pessimistic) forecast of their cash flows and how its allocation to their
depressed share price would impact their per share bottom line. And then of course overcome
the extreme (and irrational) psychological fear of Amazon laying waste to the entire brick and
mortar retail industry within 365 days.

This, however, is not a natural long term play and necessitated an opportunistic exit when one
presented itself. Retail will almost certainly continue to shrink, and Dillards has, in my mind,
perhaps a weaker brand than, say, Macy‘s or Nordstroms. As DDS rallied, echoes of Buffett‘s
Hochschild Kohn story rang increasingly louder in my head:

―Shortly after purchasing Berkshire, I acquired a Baltimore department store,

Hochschild Kohn, buying through a company called Diversified Retailing that later
merged with Berkshire. I bought at a substantial discount from book value, the people
were first-class, and the deal included some extras – unrecorded real estate values and a
significant LIFO inventory cushion. How could I miss? So-o-o – three years later I was

P a g e | 24

lucky to sell the business for about what I had paid. After ending our corporate marriage
to Hochschild Kohn, I had memories like those of the husband in the country song, ―My
Wife Ran Away With My Best Friend and I Still Miss Him a Lot.‖
-Warren Buffett, 1989 Berkshire Hathaway annual letter


Atlas Financial (AFH) entered 2018 as a top three position of ours, but on the 1 st of March,
dropped a bombshell: During their annual actuarial review, they discovered prior year losses,
particularly 2014 and 2015, were piling up at a far greater magnitude than they had reserved for.
No use mincing words here: it‘s bad. It wiped out a third of AFH‘s book value.

Worse, this is the second year in a row in which excess losses were booked in response to
inadequate underwriting in the past. In 2017, Atlas took a $17 million hit on losses in Michigan
that were tracking above estimates. At the time, I wrote that it implies a permutation of several
possibilities: 1.) Much more losses will come to light (i.e. the cockroach theory), and/or 2.)
Future profitability will be significantly impacted, and/or 3.) Mr. Market over-reacted.

I had judged #3 to be most likely and upped our stake by 25%. That worked out well in 2017, but
the lesson with insurance companies is that sometimes cockroaches take a while to reveal
themselves, even in so-called ―short-tail‖ businesses like auto insurance.

The fact is, the entire commercial auto space has actually been struggling for many years27. In
hindsight, it was my humble mistake to believe they were sufficiently differentiated by niche and
size to buck the trend. The losses revealed that the company is not the extraordinary nimble and
savvy operator capable of rising above the tide of insurance cycles that they claim to be, but
rather, an ordinary insurer in a commodity market with some advantages by virtue of their focus
on a niche. AFH fell from $18.80 to $11.10 in one day, and deservedly so. I sold to realize a
sobering 2.5% permanent loss on our capital (cost basis was ~$15/share).


An astute observer might point out, however, that AFH still appears on his/her statement.
That‘s because I repurchased some in Q3 and Q4. The easier path would certainly have been to
just sell and never look back. Rationally, however, this mistake was a sunk cost, and investing is
a perpetually forward looking endeavor. At our new cost basis of $10/share, should
management be capable of delivering even half of what they promised, returns going forward
could still be attractive. Some tailwinds:

1. Gross premiums written continue to grow. Despite getting downgraded (as expected) by
A.M. Best, their reinsurance partners have been willing to take on the extra risk as Atlas‘s
surplus level no longer support the volume of business they generate. The raw ability to
generate consistent gross premiums holds value in and of itself, because premiums =


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float, and float = investment returns. In this rising interest rate environment, a larger,
over capitalized multi-line insurance carrier with an asset management arm could
conceivably acquire this company for this reason alone.

2. Since commercial auto insurance has been so dismal across the industry, pricing is now
rising in earnest every quarter in a desperate effort to make up losses. This is what is
known as a hardening market and it gives every insurer a rising tide of pricing power
that could result in excess profits.

3. Atlas, in fact, has been raising prices higher and faster relative to industry recommended
standards since 2012. A cardinal sin that have sank many an insurer is to charge lower
prices than peers in order to win market share – prices that do not support inevitable
future losses. But as far as I can tell, this was unlikely the case here. The company‘s value
proposition was never to be the lowest price insurer to begin with.

4. The majority of the losses were placed in so-called IBNR (Incurred But Not Reported)
reserves. These losses are estimated losses, not actual cash losses (yet). IBNR reserves
are set based on 3rd party actuaries‘ calculations based on historical trends.
Management believes, according to their own internal analysis, it is excessive, and that
as time goes by, actual losses may come below estimated losses, possibly by a material
margin. In other words, portions of the losses could revert in the next year or two.

5. With the growing popularity of Uber and Lyft, the market is expanding and legislation is
catching up. Many states now require drivers to hold commercial-level insurance, which
plays into Atlas‘s strengths. In 2018, they launched a mobile app called optOn that
provides short-term, primary, commercial automobile insurance coverage for rideshare
drivers across all rideshare driving periods, with premium priced per mile. This could
open up access to a brand new market if it proves to catch on.

Qualitatively, I have followed this company for five years and watched CEO Scott Wollney
meticulously grow premiums from $20 million to over $200 million, albeit with much less
reverence than before. I still believe him to be a good insurance executive who understands his
circle of competence and operates with a long-term owner‘s mentality.

Throwing away this accumulated knowledge of the company, the industry, and its management
team would be stubborn irrationality. Atlas‘s business still harbors compounding capabilities. It
is in a niche business with a decent moat – insuring hired car service is not nearly as
straightforward as it may seem, because it requires a large cache of proprietary data around
accident rates and severities not easily reproducible. In the past, large generalist insurers have
attempted to splash into the space without the specific skills in underwriting such a risk, and
they have ended up nursing large losses over time and been forced to abandon this line. As such,
it should be capable of sustaining a combined ratio between 90-95%28.

The simplest way to understand Combined Ratio is the percentage of total expenses (loss + SG&A) to premiums
earned. Thus, an 80-90% combined ratio = a 10-20% profit margin.

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Rest assured, however, that mine rose-colored glasses are definitively off. This position will be
tightly monitored and controlled and will likely never reach our top three again.


A Look Ahead

As of this writing in February 2019, the broader market has bounced back with a vengeance
from its December lows, further validating the folly of reaching for that last minute tax-loss sale
only to be left on the sidelines while the S&P 500 stages its best January since 1987. And yet,
investor confidence as measured by State Street is at its lowest point in years29.

Anecdotally, the business media seem obsessed with identifying when the next recession is
coming, as if we enter a recession, everyone loses all their money. That is, of course, nonsense.
Strong companies welcome recessions, as it washes away marginal competitors and exposes
those who are swimming naked.

From time to time we will experience dramatic declines in quotational prices like we did in 2018.
But remember the ultimate value of a business are its assets and its earnings power, and if we
buy them at a discount and there are no erosions, there is no cause for concern. Our top two
positions, BlackBerry and General Motors, have investment grade balance sheets with net cash.
Our financials are all ―well capitalized‖ under federal regulatory definitions. Our leveraged
commercial/industrial businesses all have ample cash flows that support conservative coverage
ratios and would not have problems accessing debt capital markets for refinancing even under
turbulent conditions. And our slice of speculative distressed positions were all purchased at
bargain prices that hold asymmetric risk/return potential.


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Per usual, I make no predictions about the market price levels itself. But all in all, the prevalent
pessimism in early 2019 thus far has me contrarily optimistic. There will always be problems in
the world and the future is never certain, but if measured objectively with metrics such as
lifespan, infant mortality rate, available leisure time, etc., over the long run, things are in fact
surprisingly good 30 . The resilience of American businesses, after all, should never be

Source: Twitter: @CharlieBiello


Thank you as always for your patience and partnership. Please feel free to reach out anytime.
May you and yours experience a joyous and fulfilling 2019.


Eric Wu


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