ARLINGTON VALUE MANAGEMENT!

January 25, 2007

Dear Investors:

The year ending Dec 31, 2006 was another frustrating year. We recorded a gain of 3% net of fees
for our tax exempt fund (AVM TE) and 9.8% net of fees for our core fund (AVM), versus 15.8%
for the S&P 500. Our core fund out-performed our tax exempt fund due to a larger position in
Berkshire Hathaway. Although we recorded a gain on the year, we had over 1/3 of our assets
invested in one company (Overstock.com) that declined by 50%+. This effectively masked a very
good performance by the other positions in the portfolio.

Our average annual return in our core fund since inception is 11.8% compared to 1.1% for the
S&P 500. For the first five years we averaged 24.9% per annum, while the last two years have
brought this average down significantly. The poor performance of the last two years can be
almost 100% attributable to our investment in Overstock.com (OSTK). (A security that has been
manipulated, as we have mentioned in past reports)

My goal in this report is to give you all the relevant information relating to your investment in
AVM; the information I would want if our roles were reversed.

Anyone can look back with hindsight and say: If it wasn’t for this, or that, we would have done
great. The fact is, in the investment world you have to play your foul balls. However I think it’s
relevant for AVM investors to know that Overstock.com (OSTK) has been manipulated during the
time that we’ve held a position. The SEC has a Reg SHO list that identifies companies that have
experienced excessive/abusive naked short selling. OSTK has been on this list for 437 days!

I certainly don’t want to give the impression of deflecting blame – as ultimately we made ongoing
decisions with OSTK that cost us a significant amount of money for which we take responsibility.
(If we had avoided this single investment the net asset value (NAV) of AVM and AVM TE would
be substantially higher). However, the abuse is real, (at one point 2 million+ shares failed to
deliver) and we have frustratingly suffered as it has gone unfettered over the last two years.
We’ve attached a few docs that elaborate on this mind-boggling practice/fraud for anyone
interested.

The natural question is: Why invest in a stock that is manipulated? At first we were unaware.
After we learned about the practice we simply took the view that if the business produces strong
results over time, the investor will eventually get a return in some form (paying out earnings to
shareholders, stock buybacks, buyout…).

I vastly underestimated the powerful negative affects that a declining stock price can have on a
young company in the early stages of its growth cycle. (Employee morale, and hence employee
turnover, increased cost to raise capital at depressed prices, distraction to management, etc.)
Despite feeling cheated, there are important lessons to be learned from this experience, and we
will be extra cognizant in the future about not repeating these mistakes.

Ultimately, in early August we decided the manipulation was too much and decided to sell off a
large portion of our position. Moreover, we found an extremely attractive idea in which to
reallocate the funds. The timing has proven fortuitous as AVM has increased 45% after
reallocating the funds.

I apologize for this investment mistake which has caused such poor performance.

Let me give you a thumbnail sketch of the investment decisions we made during the year: We
maintained our very large position in Berkshire Hathaway, which increased by 24%; a nice return
– although nothing spectacular. This 24% return is more impressive when one considers the
unparalleled risk profile associated with BRK – or rather the almost complete lack of risk
associated with holding BRK. We have trimmed the position back, but continue to like this
holding and think there’s still a gap between market price and intrinsic value, although this gap
may have narrowed slightly.

The other significant performer was a new position we took after selling most of our OSTK
position. I hesitate to mention the name at this time as we may very well keep buying.

Early in the year we identified a great opportunity in Lear Corp (LEA); a company characterized
by difficult business conditions and a cloudy near-term outlook, yet quite safe and undervalued
when taking a longer-term view. We allocated 11% of the portfolio to LEA at an average cost of
around $16.50. As the stock increased in price to $19 (far below what we thought it was worth)
OSTK began another precipitous fall. A habit we routinely practice is to compare ideas between
one another, trying to optimize the portfolio on a risk/reward basis. After making this comparison
we decided to sell out of LEA and allocate the proceeds to OSTK – which continued to decline.
LEA ended the year around $30 per share, almost double our average cost.

Similarly, we experienced a déjà vu-like nightmare with Rent-a-Centers (RCII). After taking a
good-sized position we decided to sell out after a small gain – strictly because we believed OSTK
represented a better value – ultimately missing out on an almost 100% gain.

As you can see, the frustrations we endured during the year were two-fold; a deep and persistent
decline in a very large position; and two very significant opportunity costs that we correctly
identified, yet received negligible benefits from.

Despite the frustrations I've highlighted above, we are upbeat going into 2007. This excitement
stems from our belief that the circumstances we encountered - a huge position in a de-facto
manipulated stock - in 2006 are unlikely to be repeated in the future. And when one strips away
the OSTK issue, and the overall investment decisions it impacted, the underlying stock picking
performance was more in accord with the first five years of AVM - in fact, it was even better.

Late in the year we found three new companies that we took positions in. Three new names is
cause for celebration for AVM. We are confident that these names are safe and cheap – which
should give us good risk adjusted returns going forward. Needless to say, investors should expect
continued volatility because of our philosophy of concentrating funds in our best ideas. As we’ve
mentioned extensively in past reports, we don’t believe volatility is a good proxy for risk. In fact,
volatility (which we view as an asset to be utilized) is a key component that increases our chances
of providing superior returns over time – thus we welcome volatility.

GENERAL THOUGHTS ON THE MARKETPLACE ENVIRONMENT

Financial markets in 2006 were similar to the hurricane season; Both were very benign and calm
compared to history. The ocean of financial liquidity sloshing around in the marketplace - most of
which is eagerly trying to find alpha beating returns - has caused many to all but ignore risk.
Wall Street tends to overweight, and extrapolate the most recent past performance - which has
been favorable and without any serious gyrations or shocks. As a result, financial markets are
pricing in tranquility as far as the eye can see. Credit spreads have narrowed to near record lows.
The risk premiums to cover the possibility of default are near record lows. Risk premiums in
emerging markets are also near, or at all time lows. When considering the enormous amount of
“hot” money chasing market beating returns, it’s easy to see how operatives can become
complacent about risks in the marketplace. A point made more clear when one considers the
underlying dynamics of many hedge fund structures; Heads, the manager wins, and tails the
investor loses.

Many take comfort in the derivatives market to hedge risk. The number and amount of derivatives
products have proliferated at an incredible rate over the past few years. In normal times these
innovations help to spread out risk. However, it’s times of unusual shocks and distress when one
needs these products the most. Unfortunately, this is likely to be the time when these products add
to the instability as large-scale liquidations take place between a small number of counterparties. I
can’t pretend to know how derivatives will play out in the next shock to the system. My worry is
that it exacerbates the problem instead of dampening it - which is why the products were created
in the first place.

Another class of investment that has come on with a vengeance is the private equity group.
Private equity is the new must have investment elixir of the day. A near nirvana-like environment
has existed for private equity and leveraged buyout firms; a situation that certainly won't last.
Floods of liquidity, cheap financing, and record corporate profits (Corporate profits as a percent
of GDP reached 10%) has resulted in a feeding frenzy for such firms.

Private equity typically has 5-7 yrs to generate a return. At present there is $270 billion which
investors have given private equity operatives that has yet to be invested. Taking exorbitant fees
and having only five years to invest such mountainous amounts of money isn’t conducive to
patiently waiting for a really good deal - which is what produces above average returns.

Underlying interest rates are low, risk premiums are razor thin, and corporate profit margins are at
70 yr highs. I have to believe that deep down private equity managers know conditions are going
to deteriorate, weather that be higher interest rates (because of economic growth) or a slowdown
in the economy (lower corp. profits and higher defaults). The most dangerous environment is
often at the cusp of euphoria; combining maximum leverage with rosy outlooks, on the heels of
record profit growth and low interest rates, is a recipe for disaster in my opinion. Furthermore,
many players rely on a gullible public market in which they can "flip" the recently acquired
company; what is commonly referred to as an "exit strategy". (Often after increasing debt so as to
pay themselves a hefty dividend).

Private Equity funds are not the only ones under enormous pressure from investors, who
increasingly have shorter and shorter timeframes. The common theme for managers investing for
others is a seemingly blissful willingness to ignore risks, and lever up in order to achieve their
desired returns. This is manifested in the narrow credit spreads across virtually all types of
securities, which in my opinion have gone to crazy levels.

Needless to say our expertise is not in economic predictions and timing of financial shocks.
Rather we'll continue to hunt for the undervalued business with solid, trustworthy management.

In closing I'd like to thank everyone for their tremendous patience, which is both a rare quality
(see ending quote by Keynes) and a huge advantage in producing above-average returns. In fact,
the basic advantage an investor has investing in the stock market is to be able to wait for the
proverbial "perfect pitch". This advantage is taken away for most fund managers by their
investors’ short time horizons; causing managers to churn their portfolios at a mind-boggling rate.
Incidentally, these dynamics contribute to proffering up the occasional "perfect pitch" as
managers focus on near term price movements over long term intrinsic values.

Recently I've looked at the history of our performance, as well as the history of some of the
various paper portfolios I’ve casually kept over the years. In doing this I've come to the
conclusion that we (AVM and investors) have a huge advantage, as well as a huge opportunity by
investing in smaller cap companies. These companies are too small for the big Wall Street players
to invest in, and are less scrutinized by the market in general. These dynamics improve our
chances of finding mispriced companies in which we can profit. I'm very excited about the future
and will spend extra time mining the small cap arena in which the history of my paper portfolios
suggest very attractive return opportunities.

I appreciate your patience and look forward to reporting to you again next year.

Sincerely,
Allan Mecham

“He who tries to pick long-term value stocks must surely lead much more laborious days and run
greater risks to his career than he who tries to guess better than the crowd, how the crowd will
behave. Human nature desires quick results. There is a peculiar zest in making money quickly. It
is the long-term investor who will, in practice, come in for the most criticism. If he is successful,
that will only confirm the general belief in his rashness and, if in the short-run he is unsuccessful
— which, of course, is very likely — he will not receive much mercy.” - J.M. Keynes
The information contained herein is a reflection of the opinions of Arlington Value Capital (Arlington) as of the date
of publication, and is subject to change without notice at any time subsequent to the date of issue. Arlington does not
represent that any opinion or projection will be realized. All the information provided is for informational purposes
only and should not be considered as investment advice or a recommendation to purchase or sell any specific
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style of any Arlington investment vehicle will, or is intended to, resemble that of the mentioned indices. The
comparison of this performance data to a single market index or other index is imperfect because the former may
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