During his recent interview with Tobias, Steven Kiel of Arquitos Capital discusses special situation investing and ‘transition companies’. Here’s an excerpt from the interview:
Tobias Carlisle: So, Arquitos, that’s your fund you’ve been running since 2012, it’s returned 16.9% after fees, and it says in the document that you sent through that you’re a special situations, so do you want to just talk a little bit about what you do at Arquitos?
Steven Kiel: Yeah. So, I mean special situations can mean a lot of different things. To me I’m looking for companies in transition, I’m looking to maximize company specific situations and minimize external things. So, it’s a variation of value investing and the way that I apply it based on my personality, but requires concentrated approach, a lot of aligned interests with the companies themselves, but ultimately I’m looking for companies that are in transition and that I can acquire at a reasonable price.
Tobias Carlisle: So, I saw you described it as having a strong balance sheet and then some pathway to free cash flow, so you’re looking for something that the business’ strength isn’t reflected yet in the financial statements, is that right?
Steven Kiel: Yeah. So, I do something called balance sheet to income statement investing, and it’s based on a quote by Peter Cundall, back in the day he said he buys on the balance sheet, sells on the income statement. Now, I don’t want to sell, but how do you acquire things at reasonable prices in this environment, applying a Graham-style approach? And to do that you have to find things a little bit earlier I think than in the past, or you have to find things that there’s a little bit more uncertainty in the public reports, but you can follow some of the incentives in the company themselves. Whether it’s because of incentives to attract the strongest capital allocator, use insider ownership, alignment of interest, and that type of thing.
Steven Kiel: There might have been, back in the day, five years ago, there were things like tax loss, [inaudible 00:02:56] was more important as well, and other type of off balance sheet items or incentives based on that. So, I want to buy when the balance sheet is strong, when it’s reasonably priced, when there’s something specific going on at the company that might unlock that value over time. And then there’s a transition that would be made to, you know, reinvestment opportunities, predictable free cash flow generation over time, that’s where I want to continue to own and hold on to a company over time, hopefully for many, many years or decades.
Tobias Carlisle: So, that’s a pretty good statement of the theory. Can you give some examples of how you have applied that in the past?
Steven Kiel: Yeah. Well, with a larger company, even a Bank of America or some of the banks coming out of the crisis, where there was several years where they were trying to strengthen their balance sheets. And they had their repurchase and capital allocation decisions were controlled, either by the government or different regulations. And you’re looking from 2009, 10, 11, 12, especially with the TARP warrants with all the major banks, there was a great opportunity there to really get quite a bit of value by buying on the balance sheet, buying for balance sheet purposes. And then, most of those banks over the last few years have now made the transition of having predictable cash flow generation and predictable return of capital. And even today you can get really reasonable and attractive returns simply based on return capital alone.
Steven Kiel: Now, that’s an example for a larger company. I owned Bank of America TARP warrants for many, many years, and actually owned it for about a five year period, the price didn’t move at all. And then after the election when Trump was elected, the next month it doubled, and then a few months later it doubled again. So, over five and a half years it looked like a tremendous investment, but for five years it could have been accused to be a value trap there.
Steven Kiel: But then all the way on the other side there’s great examples for smaller companies that we’ve owned as well that are a little bit more unique I think.
Tobias Carlisle: Well, let’s talk about those smaller companies. I actually participated in that TARP warrant, and I’ve found that later, so I got very lucky with that. But let’s talk about the smaller companies.
Steven Kiel: Yeah. There’s a company today that’s my largest position, and it’s called MMA Capital. And it’s made the transition over the last six or seven years, from this balance sheet type of approach, reasonable valuations, to now it’s transitioned into the income statement predictability. Other investors haven’t really realized it yet, and it’s also a very small company, it’s a $200 million company and it does have tax loss carried forward. So, you’re not able to own more than 5% of the company. So, this is good for small funds, it’s good for personal accounts for larger investors. But it’s a little bit of a complicated story, and so it’s not attracting. It’s too small for very large investors, but it’s a little too complicated for general retail investors. So, it’s good for our sweet spot with the smaller fund.
Steven Kiel: The background there was, there were a number of off balance sheet items, off balance sheet assets through the years. They were buying back about 10% of the company per year for four, five, six years in a row. A lot of insider ownership, alignment of interest. And again, we’re not paying any taxes on the assets that they were selling, so the balance sheet, the book value was growing every year. And they were transitioning into a different type of business, and their specialty asset manager, and now their primary business is much different than it was five years ago.
Tobias Carlisle: What’s the transition been?
Steven Kiel: Yeah. So, their primary business now is a solar lending fund. And they partnered up with ironically Bank of America several years ago. And they’ll likely throw off six dollars a share next year just from their returns from the solar lending fund. Trade’s at $32, book value’s 37 and change. And so it took several years to create that predictability, but now you’re there and we’re just waiting for last 12 month comparisons, and then it’ll start showing up on screens, and then because it trades below book value it also throws off so much of this return. Over the next year we’re going to have income statements, [inaudible 00:07:34] investors start buying into the company that we’re not interested in the company for all those years where it traded at 80% of book, but did not create a predictable cash generation.
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