I NCANDESCENT CAPITAL

February 9, 2018
Dear Investori:

Our portfolio rose 3.51% in Q4 versus the S&P 500‘s rise of 6.64%, bringing our full year
(unaudited) gross return to 23.66%. This compares to the S&P 500‘s total return of 21.83%. The
charts below show our performance figures year-to-date and since inception:

Incandescent S&P 500 Difference

2017 Year 23.66% 21.83% 1.83%
Since Inception (60 Months) 122.01% 108.13% 13.88%
CAGR 17.28% 15.78% 1.50%

Returns Since Inception

Incandescent S&P 500 Total Return

140.00%
120.00%
100.00%
80.00%
60.00%
40.00%
20.00%
0.00%

Last 12 Monthly Returns

Incandescent S&P 500 Total Return

15.00%

10.00%

5.00%

0.00%

(5.00%)

(10.00%)
J F M A M J J A S O N D

222 Broadway, 19th Floor • New York, NY 10038 • 646-912-8886 • www.incandescentcapital.com

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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%
CAGR 18.88% 15.24% 3.64% 2.51% 16.37%

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

$500,000 $474,078

$450,000
$400,000 $358,353
$350,000
$300,000
$250,000
$200,000
$150,000 $124,965

$100,000
2008 2009 2010 2011 2012 2013 2014 2015 2016 2017

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 2017, if you elected our standard 20% performance fee (no hurdle, no management fee)
arrangement, your net return would be around 18.9% compared to your gross return of ~23%.

1
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.

***

2
Charlie Munger has called understanding the psychology of human misjudgment a “superpower”.
3
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

8.0%
20.5% 21.4%

10.3%

92.0%
6.7%
5.5%

Cash Canada USA

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

Investment "Type" Consumer Sectors

Cyclicals
Special 12.7%
Situations
8.8%

Mispriced Tech
26.3% Energy
30.5%
13.1%

Compounder Other
64.9% 14.2%
Financials
29.5%

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, telecom,
industrial, and basic materials.

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***
The S&P 500 has had only one down quarter out of the past five years. One! (Q3 of 2015.) In
2017, it booked 12 out of 12 positive months, a ―perfect‖ year. That‘s a record. It has
compounded at 15.78% per annum since 2013. At that rate, capital doubles approximately every
five years. We‘ve managed to stay a nose ahead thus far, but should the S&P match or exceed its
rate of return over the next five years with the same, non-existent volatility of a death march, it‘s
probably only even odds we will be able to keep up. As a value investor, I commit capital only to
assets that I understand to be undervalued. A market that does not sell-off or even mildly
correct itself is a market that offers slim pickin‘s of discounted securities. Ergo, as valuations
inflate ever higher, not only will our cash balance increase as I trim our dear holdings, said cash
will have trouble finding new prospects to invest in.

To wit, we begin 2018 with a cash balance of ~20%. That‘s historically higher than our average
of between 10-15%. Also notice: Compounders now consist of almost 65% of our invested capital,
compared to just 37% in Q3. This is not because I made any dramatic buy/sell decisions in the
fourth quarter – it‘s because our largest position, BlackBerry, once a mispriced, misunderstood
security, has turned the corner and been re-rated by Mr. Market. Accordingly, it is no longer
―mispriced‖, but has instead been re-categorized as a promising compounder given its pivot
towards a long runway of re-investment opportunities in a large and growing market.

A ballooning cash pile and a growing preponderance of Compounders vs. Mispriced or Special
Situation securities is the organic evolution of our portfolio‘s composition in response to the
market‘s inexorable climb. This will inevitably dampen investment returns. But to try to fight
this would be to betray our value-oriented strategy. Numerous erstwhile value investors in
recent years have, in valiant attempts to keep pace with the locomotive S&P, drifted, either by
lowering their valuation standards, or adopting shorter-term momentum strategies, or, most
dangerous of all, increased their usage of leverage. For some it has worked, and for some it has
not. But as the inimitable Charlie Munger puts it, sometimes the worst thing that can happen is
to succeed… because it only encourages you to do it again. Few investors have the balletic
ability to pirouette between strategies with oracular timing consistently. I certainly do not. And
thus I am compelled to actively lower your expectations of our future returns should the current
market environment persist indefinitely.

In contrast to this dour admission is the relative unlikelihood of another five years of double-
digit S&P gains sans turbulence 4 . Indeed, even in the preceding five year period of
unprecedented tranquility, there were enough squalls to be opportunistic, e.g. partners who
heeded my calls for capital between Q3 of 2015 to Q1 of 2016 have since enjoyed a boost to their
bottom lines (excavate my letters during those periods for evidence). Most importantly,
individual securities themselves are wont to offer periodic entry points to enterprising investors.

So anyway, enough of this highfalutin preaching. Let‘s get down to business and talk stocks.

4
N.B. that as of this writing in early February 2018, the general market has finally experienced a mild correction
exceeding 5%, the first time in 24 months. Ignore the hysteria on business news. This does not count – not yet.

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Table of Contents

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

BlackBerry........................................................................................................................................7

General Motors .............................................................................................................................. 11

Banking & Insurance ..................................................................................................................... 13

Atlas Financial ............................................................................................................................ 13

Heritage Insurance Holdings ..................................................................................................... 14

Customers Bancorp .................................................................................................................... 15

CIT Group................................................................................................................................... 16

Takeouts ......................................................................................................................................... 17

Whole Foods ............................................................................................................................... 17

Calpine........................................................................................................................................18

Dynegy ........................................................................................................................................18

A Quick Tour Of A Few Others ...................................................................................................... 19

―Billy‖ ...................................................................................................................................... 19

Dish Network ......................................................................................................................... 19

―Ricardo‖................................................................................................................................ 20

―Daphne‖ ............................................................................................................................... 20

Dillards ................................................................................................................................. 20

Mistakes ......................................................................................................................................... 21

CBL & Associates Properties ...................................................................................................... 21

A Look Back and A Look Ahead .................................................................................................... 22

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BlackBerry

For the past three and a half years, BlackBerry (BB) 5 has been our largest position. In 2017, it
was also our biggest winner, rising 62.1% and contributing ~12% to our overall gains. 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 (BlackBerry Storm, anyone?), 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 last year‘s annual letter and
reproduced here for convenience:

1. The unheralded money maker in most tech enterprises is their high margin software services
business – software is akin to the razorblade versus the hardware‘s razor. Despite the
company‘s claim to fame being the BlackBerry smartphone, it was actually the monthly
service access fees (SAF) filling their coffers with profit. So even as their fate in hardware
was doomed, the residual SAF continued to flow in, providing them a cushion for a soft-
landing. More importantly, the technologies behind the SAF was software. Software that
could efficiently compress and encrypt network packets, software that provided cyber-
security and controls to IT departments that manage thousand-strong 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. Good 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

5
The ticker changed from BBRY to BB in October 2017 when they moved from the Nasdaq to the NYSE stock
exchange. This was, by my estimation, largely a marketing/branding move, done to buff a “prestige” of being on
The Big Board. There will be no discernable difference to passive shareholders like ourselves.

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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 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
spent $800 million throughout 2014 and 2015 on acquisitions to fill out a complementary
portfolio of offerings and hired Carl Wiese and Richard McLeod from Cisco to build out a
world-class sales force and channel partners ecosystem. Overall software revenues will likely
exceed $700 million for fiscal 2018, 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 so expensive, 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.

BB common stock finally got their due in 2017, appreciating from $6.89 to $11.17 per share,
helped along by an unexpected $940 million (~$1.75 per share) refund from Qualcomm due to
royalty overpayment in the past. As such, much of the easy money has been made, and it should
no longer be considered a mispriced security. It is also my guess that we will not enjoy such a
dramatic rise this year. Mr. Market has already re-rated the stock, giving it credit for its
transformation from a low-margin hardware shop to a high-margin software shop. Furthermore,
growth will likely flatline for the foreseeable future as the enterprise mobility management
market is down to single digit growth rates.

In the past, this would have been enough impetus for me to sell our stake. However, as
mentioned earlier, it is exceedingly rare to invest in this type of business at a decent valuation.
We now have in our possession pieces of a valuable asset at a low cost basis which is currently
trading for a fair (or perhaps a wee bit expensive) price. Further appreciation, although maybe

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not as dramatic and maybe another several years out, is highly likely over the long run. Given
the dearth of reinvestment opportunities out there, swapping our stake in BB for mere cash is
unattractive, especially as we are now sitting on a cost basis in the mid-$7‘s. This is not to say I
have not or would not trim off profits, but I am dis-inclined to trigger large tax payments despite
already achieving long-term status.

Thus, the analysis at this juncture must focus on future value, of which there are two key
components:

1.) What are the prospects of BlackBerry‘s existing growth efforts, and
2.) What are their prospects for continued intelligent reinvestments further into the future?

***

Within the next three to five years, the best hope for growth comes from QNX, a real-time
operating system 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
with which they built their excellent-but-too-late BB10 mobile OS on6. Prior, it was owned by
Harman International, 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 the automaker OEMs‘ cars and today is in 60 million automobiles, a
market share north of 50%.

An operating system is heinously complex and is easily the most important piece of software in
any PC, mobile, desktop, server, ―thing‖, or otherwise. 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. It‘s no wonder in the history of computing, there have been only a handful of
major OS‘s such as Unix, Linux, and Windows7.

QNX itself is a derivative of Unix and has been around since the ‗80s. BlackBerry is leveraging
its reputation for safety and reliability as well as its established footprint in the automotive
supply chain to push QNX into the new frontier: advanced auto technologies, the most high-
profile of which is of course self-driving technology. The car of tomorrow will have, if not full
level 5 autonomous capabilities, advanced driver assist, over-the-air updating, dynamic software

6
Today, despite its app-starved condition, BB10 devices remain the single most unflappable, reliable smartphones
I have ever owned. They never crash and have Methuselah-ian battery lives. If 90+% of what you do with your
phone is e-mail and texting and web browsing, I recommend you try a BB10 device (available on Amazon), either
the BlackBerry Classic or the BlackBerry Passport. They can be had for < $200.
7
You may have heard of more, e.g. Solaris, BSD, Red Hat, etc., but they are all derivatives of either Unix or Linux.
Even Android is a derivative of Linux, while iOS and macOS are derivatives of BSD which itself is a flavor of Unix.
OS’s are so valuable and complex that it’s often smarter to buy one than to develop one from scratch. Android
was purchased by Google for $50 million, and the core of iOS and macOS stemmed from NeXT (which was where
Steve Jobs was exiled) which was purchased by Apple after they failed for years to develop their own.

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powered instrumentation, communication with both ―smart‖ infrastructure and other active
vehicles, and many more innovations that will revolutionize the driving experience. All of this
will be powered by software and will be connected over 5G wireless. Cars will be more computer
than engine + wheels, and the hope is QNX will underpin much more than just your radio
station tuner.

To date, partnerships have been struck with a variety of Tier-1 suppliers such as Bosch, Aptiv
(f.k.a. Delphi), Denso, and Magna, as well as with technologists like Qualcomm, NVIDIA, and
Baidu. All of these relationships represent potential, but it will take time to convert these design
wins into recurring sales. It is not currently possible to quantify how long nor how much, but
there is significant momentum and I am confident this is no longer science fiction. The R&D and
political will 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. BlackBerry stands a
good chance to grab a slice of this gigantic pie, of which even the thinnest could multiply their
current annual revenues8.

Automotives are 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. In my
opinion, its 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.

***

Tackling the second question of longer term growth requires scrutinizing management‘s re-
investment capabilities. As mentioned above, subscription enterprise software businesses have a
number of attractive economics such as no tangible costs, deferred revenue ―float‖, and above-
the-line ―capex‖ in the form of R&D which reduce taxable income. As such, the capital allocation
abilities of management is critical over the long haul. It is otherwise too easy to vaporize the
prodigious cash flows of such businesses with ill-advised investment programs. BlackBerry only
needs to look to its own history for painful lessons.

With John Chen as Chairman and CEO and Fairfax‘s Prem Watsa as the company‘s largest
shareholder, there is a multi-decade track record of intelligent investment conduct. BlackBerry‘s
acquisitions since present management took over have been measured and successful. Their
largest, Good Technology for $425 million, was a classic distressed asset scoop for less than 50
cents on the dollar9. If anything, more criticism has been probably applied re: the opposite –

8
The excitement for QNX’s potential within the company was greatly heightened (“sent shockwaves through the
building”) upon the news of the return of Gordon Bell, co-founder of QNX, who, last year, at the ripe old age of
62, is “having the time of my life. I see a company that’s turned around.” (http://ottawacitizen.com/news/local-
news/after-13-year-hiatus-qnx-cofounder-returns-to-company-to-spur-expansion)
9
Fun (for us, but not for ex-Good shareholders) quote: “Around 9 a.m., hundreds of employees filed into a
conference room or started up videoconference software to watch Good’s chief executive, Christy Wyatt, discuss

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that they have not been aggressive enough in acquiring more revenues, for despite spending
$800 million from 2014-2015, they are still sitting on $2.5 billion in the bank. But to me,
discipline in not over-paying, especially in a red hot tech sector that is routinely overvaluing
businesses barely out of the garage, is far more important. It jives with mine own value-oriented
sensibilities, to keep our heads whilst everyone around us are losing theirs. As long as the
Chen/Watsa duo is at the helm of this ship, we should sleep pretty well knowing our equity is in
responsible yet opportunistic hands.

A further comment on management: Our initial investment thesis hinged on John Chen‘s
continued involvement with BlackBerry. I do not believe the turnaround would have succeeded
without him, as he actively recruited a small army of his former mates from Sybase and SAP to
fill out the senior management ranks and leveraged connections from his time with private
equity giant Silver Lake and the boards of Wells Fargo and Disney to bolster BlackBerry‘s
credibility at a time when it was exceedingly shaky. As such, from 2014 to 2017, had Mr. Chen
left the company for any reason, our thesis would have been busted. Happily, we were spared
that conundrum.

Going forward, I believe the criticality of his presence for BlackBerry‘s continued success is
somewhat diminished with the company stabilized and its strategy well defined. Should he elect
to retire once his 13 million restricted stock units fully vest in 2018, we may very well remain
shareholders depending on who the reins are handed off to.

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 / disaster compensation czar
Kenneth Feinberg10 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 last year‘s annual letter, 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

the sale. Ms. Wyatt introduced BlackBerry’s chief, John S. Chen, who winkingly apologized for how his deal
makers had driven Good’s final sale price down to $425 million, less than half of the company’s $1.1 billion
private valuation.” (https://www.nytimes.com/2015/12/27/technology/when-a-unicorn-start-up-stumbles-its-
employees-get-hurt.html)
10 th
Who also headed the Sept. 11 Victim Compensation Fund and the BP Deepwater Horizon Disaster Fund.

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York Stock Exchange with a strike to purchase GM common for $18.33 per share expiring on
July 201911. In 2016 I began swapping GM common for GM warrants, which, given that shares
are trading significantly above the strike, act as de facto leverage12, allowing us to increase our
exposure without spending more cash13. Our 6-7% position roughly represents a synthetic 13%
position in the common, which is why I coin it our second largest position despite it not
appearing so on our statement – a little mental reminder that I am applying leverage here.

GM WS B rose from $17.16 to $23.40 in 2017, a 36.4% gain. The company‘s fundamentals
remained steady in a U.S. market that is, while plateauing after a seven year expansion,
experiencing a secular shift towards trucks, SUVs, and cross-overs, the bread and butter of GM.
The stock made most of its up-move from September 2017 onwards, when excitement
surrounding its autonomous driving efforts, now believed by industry experts to be at least on
par with Tesla and Uber and Waymo, jump-started its shares, altering investor perception that
the driver-less future is not the apocalypse for an old line auto OEM.

What further separates GM from its Silicon Valley competitors is something perhaps just as old-
fashioned: profits. Per-share profits for FY 2017 will likely show a slight bump from the year
before period, somewhere on the high end between $6.00 and $6.50 per share, which does not
sound terrifically impressive at first glance, especially when compared to the torrid growth of
the tech darlings, but when gauged against its $40.99/share stock price at year-end, becomes an
immensely attractive < 7x P/E ratio.

Why GM‘s shares continue to trade at such a depressed valuation will make for an interesting
case study in the future. Bear arguments vary, but most of them 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 trough.

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.

11
The warrant was issued as part of their restructuring in 2009.
12
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.
13
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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In the end, this boils down to a simple thought experiment: do you believe the structural
cyclicality of this industry is a permanent, unavoidable phenomenon, or do you believe there are
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? By the virtue of our long position it is
clear what my beliefs are. The cyclical pressures of selling cars is indeed strong, but not un-
manageable and proof exists in the form of Toyota Motors, the best-in-class operator which has
experienced a consistency in sales and profits extending through multiple cycles. GM is not
Toyota, not by a long shot—not yet—but I believe they have the right financial structure 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 should continue to
provide us a highly satisfactory result over time.

Banking & Insurance

Our insurance holdings provided perhaps the most ―excitement‖ I‘ve experienced this year. In
my Q1 letter, I mentioned that a couple of them sold off, both to degrees that overshot any
fundamental reasoning, and, both of which I subsequently invested more into.

The first was Atlas Financial (AFH), a top three position of ours which specializes in the
niche corner of taxi, limo, and paratransit commercial auto insurance. Atlas reported a
significant ―reserve strengthening‖ in late February last year, which is insurance lingo for
bigger-than-expected losses. Economic net impact amounted to $17 million, but its stock shed
about $40 million in market cap in the aftermath. 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.

After much thought, I judged #3 to be most likely and upped our stake by 25%. With small cap
insurance companies though, you can never entirely rule out #1 and #2, but having followed this
company for four years and watched CEO Scott Wollney meticulously grow premiums from $20
million to over $200 million, my inclination was to believe him when he asserted that this
reserve strengthening was an isolated event related to specific laws and circumstances in
Michigan that allowed lawyers to pursue large personal injury claims. Mr. Wollney promised the
state would be < 1% of Atlas‘s overall book of business by year-end — better to exit a wretched
place than try in vain to write profitable insurance there.

AFH started 2017 at $18.05 but crumpled to $13 following the news, which is the price where I
added shares. Subsequent quarters revealed no further damage from Michigan (or any other
states) nor discernable impairment in earnings power or growth trajectory, which helped AFH
to rally methodically for the rest of the year. The stock ended 2017 at $20.55, a 13.9% gain, but
our opportunistic trading boosted our IRR to 21%, which actually ended up being the second

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largest dollar amount contributor to our overall bottom line. AFH is now, by my estimation,
fairly valued, so I have sold those booster shares.

Atlas remains a large position for us because of its compounding capabilities. It is in a niche
business with a wide 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. As such, it is capable of sustaining an enviable combined ratio between
80-90%14. 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. Furthermore, 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 nicely.

The thesis also rests on the belief that Scott Wollney is a rational insurance executive who
understands his circle of competence and operates with a long-term owner‘s mentality. This
means a focus on underwriting results and not on chasing premium dollars of lesser quality.
2017‘s fiasco in Michigan notwithstanding, this focus has generally held up.

***

The other insurer was Heritage Insurance Holdings (HRTG), a property catastrophe
insurer based in Florida. Heritage suffered a general malaise for much of 2017, with shares,
which started at $15.67, drifting down to $12 and below with no apparent catalyst. This is not
uncommon, by the way, especially with small cap stocks which are easily moved by a medium-
sized fund in excitement (or despair). In August, they announced a large acquisition of a private
insurer in the New England, NBIC, which, perhaps since it required jamming a $125 million
issue of convertible debt into the market, drove shares further down into the $11 range. And so,
throughout the course of the year, I bought scoops of it here and there as it flip-flopped around,
building it up to an 8-9% position by September.

Then the excitement really started. 2017 was an abnormally active hurricane season, setting a
record for activity in the Atlantic Ocean with Hurricanes Harvey, Irma, Jose, and Maria all
making landfall as category 4 or 5 behemoths. Irma, in particular, was of interest to me because
as it strengthened, it made a beeline towards Florida, and in particular, Miami, ground zero for
the most expensively insured properties in the entire state. Heritage and its peers suffered
indiscriminate sell offs as Mr. Market entered into one of his patented depressive moods.

HRTG went from $11 to $9, sinking 30% below book value, a draconian haircut that assumes
Irma will probably be the single most destructive hurricane in Florida history, inflicting
inflation-adjusted damages more than twice that of the previous record-holder Hurricane
Andrew. The sell-off was egged on by hysteria in the media, several doing what were essentially
hit pieces on Florida-based regional insurers, giving the impression that they were all thinly
capitalized and thus had questionable wherewithal to withstand a major hurricane when in fact,

14
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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almost all of them have significant reinsurance capable of surviving Andrew-level losses easily.
You may recall I wrote about this in my Q3 letter, which you can refer back to for a more
detailed blow-by-blow and footnotes.

Long story short, Irma veered slightly west, sparing Miami the worst, but still dealing extensive
damage due to her colossal wind field which basically covered the entire state longitudinally.
Heritage sustained gross losses of approximately $400 million, but net of reinsurance, losses
were capped at a $20 million retention. For perspective, they could have suffered four Irmas
and still not exhaust their total $1.75 billion reinsurance tower. HRTG shares rebounded
immediately after the hurricane passed and did not look back, closing the year at $18.02 per
share, a 15% gain year over year. But our opportunistic buying, as it did with AFH, beefed up our
IRR to 24%.

We continue to own Heritage and I consider it still to be attractively priced. Moreover, I

consider this space to be more inefficient, more prone to market hysteria, and therefore I have a
discernable edge developed over following this industry for years. However, Heritage does not
enjoy as wide a moat as Atlas does 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, their NBIC acquisition will be an interesting
development to follow, as it immediately pushes their written premiums past $900 million but
more importantly diversifies them out of Florida significantly. Together they will represent a
―super regional‖ insurer with more scale to throw around.

***

On the banking side, our big winner in 2015 and 2016, Customers Bancorp (CUBI), had a
miserable 2017, declining -27.4% from $35.82 to $25.99. This was not, to me, a great surprise. I
wrote in last year‘s letter that repeating their outstanding performance would be unlikely due to
the P/B multiple expansion that has already valued them in-line with their peers. Subsequently,
I sold about half of our stake in Q1 for $33.89 per share.

Customers is a regional business bank serving the New York/New England area that eschews
brick-and-mortar branches and instead recruits banking teams who travel to client sites to
conduct business and have deep roots within each local community. The benefits of this
―concierge‖ model are multiple. CUBI 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 0.30% of assets compared to peer/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

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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.

What derailed 2017 was their BankMobile subsidiary, a digital bank venture targeting young
millennials started in 2015 by Mr. Sidhu‘s daughter, Luvleen. For most of the year Customers
was trying to sell it for at least $100 million. In March, they announced Flagship Community
Bank agreed to pay $175 million in cash for BankMobile, a strange deal considering Flagship is a
podunk two-branch bank in Florida with an equity book value of just $13.2 million. Not
surprisingly, Flagship was unable to come up with the financing necessary to close, and instead,
by year end, Customers agreed to do a spin-off of BankMobile followed immediately by a share-
swap merger with Flagship with the resultant entity retaining the BankMobile name.

The dramatically increased complexity of this deal, now slated to close in mid-2018, drained
time, expenses, and management attention away from the core Customers Bank business, and
muddied the quarterly results. Furthermore, they had to cap total assets to less than $10 billion
due to a regulation that would have restricted the bank from charging debit card fees, the main
impetuses to sell BankMobile in the first place. Net income per share, which had been growing
15-20% like clockwork for the past three years, fell -15% in 2017.

While it‘s unfortunate that these events dragged down their overall results, the core economics
and low-cost advantages of the business remain intact. We remain shareholders, living with the
understanding that Jay Sidhu, while a talented and accomplished banker, has a tendency to take
the occasional oddball risk now and then. The BankMobile saga should come to a merciful end
this year, and the bank itself should once again return to 15-20% EPS growth, with $2.75 to
$3.00 per share within reach, a completely acceptable ~10x P/E valuation at today‘s prices.

***

On a happier note, our other bank holding company, CIT Group (CIT), advanced drama free
in 2017 from $42.68 to $49.23 for a 15.3% gain. CIT is a middle-market bank that has, over the
past several years, transformed from a hodge-podge collection of global lending businesses
overly reliant on high-cost capital markets for funding into a legitimate mid-sized commercial
bank focused on serving the United States with a growing low-cost deposit base. Its
transformation has been a multi-year affair, after 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 2017, it
was finally sold. Also sold were their commercial aircraft leasing business as well as their
European railcar leasing business. The end result is a much slimmer company more focused on
their historic niche in the middle-market with a dramatically improved funding structure.

Ellen Alemany has been CEO now for two years and she and her management team have proven
to be impressive operators, methodically chopping off extraneous pieces of the business, selling

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them for good prices, excising the damage from the OneWest acquisition, getting back on the
bank regulators‘ good side, using the proceeds to buy back $2.75 billion in common stock, and
studiously marching CIT back towards a 10+% ROE earnings power. Here is a fun slide
showcasing just how much muck Ms. Alemany‘s team had to hack through to reach a semblance
of normality over the past two years:

Figure 1: Noteworthy items impacting earnings (use a magnifying glass)

This year we should see CIT hit that 10% ROE mark, with the distinct possibility of reaching 11-
12%. With shares still trading right around tangible book value, we stand a good chance of
enjoying further double-digit gains over the next year or two.

Takeouts

I have often written about one of the beauties of value investing is that if you‘re directionally
correct with your analysis and valuation, even if Mr. Market eternally disrespects your stock,
eventually someone will come along and scoop up the entire enterprise. This came true several
times in 2017 for us, contributing about 2.75% in gains to our total capital.

The first was Whole Foods (WFM), a name I highlighted in my Q2 letter‘s Case Study. WFM
was acquired by Amazon for $42 per share, netting us an approximately 40% gain over 1.5 years.
Prior to 2015, I would never have thought of being able to buy WFM at an un-obscene valuation.
But thanks to a series of operational miss-steps that led to several sloppy quarters, the market
offered us WFM for 13 times cash flows ex-store expansion costs in late 2015. 13x may be a bit
more than I usually pay for a stock, but perhaps I‘ve listened to Warren Buffett lecturing about
See‘s Candy one too many times and have internalized the qualitative value of a platinum brand
with a history of success and plenty of expansionary runway left.

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Shares were relatively range-bound for over a year, but things started heating up in Q2 after
Jana Partners, an activist hedge fund, took a big stake and pressed aggressively for changes,
threatening to overhaul the board if their demands were not met. On June 16th, Amazon
announced their bid, effectively a white knight coming to Founder/CEO John Mackey‘s rescue.
And while there was no way I could have guessed Amazon would be how we monetized our stake,
I didn‘t have to. Good things happen when you look for situations where there are multiple ways
to win, often coming completely out of left field, and very few ways to lose.

The other takeouts were two companies in the Independent Power Producer (IPP) space. The
first was Calpine (CPN), a name we‘ve also owned since 2015, attracted by its fleet of best-in-
class natural gas power plants as well as their geothermal assets that are increasingly valuable in
a world moving inexorably away from dirty coal and towards more efficient and renewable
energy sources. It turned out I was a too early, as our CPN position, established at $16 per share,
ratcheted down to $10 in Q2 last year. The company suffered mightily from persistently low
electricity prices and competition from a glut of newly built plants. I managed to lower our cost
basis to $13, but the complexity of the U.S. power market with all its different regulatory zones
and political incentives and fluctuating commodity prices kept me from averaging down our
position too aggressively – I am aware I don‘t have much of an edge here except patience.
Fortuitously, in late summer, Calpine agreed to be bought out by private equity group Energy
Capital Partners for $15.25 per share. This was an admittedly difficult investment where the
outcome brought me as much relief as joy.

Dynegy (DYN) was the other, an investment I alluded to having initiated in my Q1 letter.
Spring of 2017 was really the nadir of the IPP space, about as hated as I‘ve ever seen a sector in
my entire career. Dynegy was at ground zero of the pain, a name saddled with debt, too many
coal plants, and grappling with a $3.3 billion acquisition of even more power plants at a time
when investors preferred slimming down as opposed to bulking up. Yet, as Howard Marks oft
states, there is no good/bad investment, only a good/bad price, and DYN holders, in the midst of
this agony, were willing to part with their stock for a mere 3x free cash flows (FCF). Despite all
the hair and complexity, it was irresistible, so I legged into it at a cost basis of $7.86/share.

An equity valuation at 3x FCF is often a harbinger of doom, a sign that investors have almost no
confidence in the company ever achieving any profitability for common shareholders. Generally,
unsecured bonds of such abandoned equities would also carry a large haircut of, say, 70 cents on
the dollar or less. Oddly, though, Dynegy‘s 7-year bonds were trading above 90 cents on the
dollar, implying there were no real worries from that investor base. When there are conflicting
signals between the stock market vs. the bond market, more often than not it‘s the bond market
you should listen to15.

Sentiment shifted after the Calpine acquisition. It signaled that companies are in play, and there
are deep-pocketed hunters looking to capitalize on the stubbornly depressed valuations. In
October, Vistra Energy announced they will merge with Dynegy in an all stock deal, sending

15
The bond market is often called the “smart money” market for the reason that most of its inhabitants are
professionals who invest with the priority of not losing money, while the equity markets are played by many,
many laymen whose goal is primarily speculation.

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DYN shares above $11. The combined company will retain the Vistra name and gain geographic
diversification, operating efficiencies, and economy of scale benefits. Importantly, Vistra, itself a
restructured entity that went bust during the financial crisis, has the balance sheet to support
Dynegy‘s existing debt levels. I believe this deal is a good one for all shareholders and thus I plan
to exchange our DYN shares for shares in the new Vistra.

A Quick Tour Of A Few Others

 “Billy”, the Canadian alternative energy power producer I first talked about in my 2014
investor letter16, 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, driving their stock up another 22.7% in 2017, an ideal compounder
and Exhibit A as to why compounding works:

Figure 2: A five year chart of "Billy", a boring but steady compounding machine

 Dish Network (DISH) declined -17.6% in 2017 as the great M&A Dance of Telecoms
never came to fruition. As the world hurtles towards a 5G wireless future, Dish is well
positioned to compete with its large swath of virgin spectrum, meticulously accumulated
over the past decade by boss Charlie Ergen and now substantial enough to create a
stand-alone nationwide network. Prior to last year, most analysts speculated that Mr.
Ergen‘s purpose in hoarding this cache is to flip it to AT&T or Verizon for a profit, but it‘s
becoming apparent that short of a Godfather offer, his intent is to build a real business
around it. Buyers of the stock hoping for a quick payday have since sold their shares in
disappointment. 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

16
Which I will continue to demure from revealing for now due to… political reasons. Call me if you want to know.

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long game17. Indeed, with much of the speculative froth blown off, DISH has become
increasingly attractive. At its current price, you are paying ~10x free cash flows for its
pay-TV business with everything else thrown in for free.

 “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 a private equity fund with permanent capital, essentially the vehicle 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, even electing to delist from an expensive stock exchange. ―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. Early indications are promising, but
more time is needed to see if they can successfully transition into a Compounder.

 “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
the highest risk investment in our portfolio, an extremely distressed situation where
management is racing to consolidate warehouses while buying up niche companies with
sustainable business models to replace their own. Thus far, a little over a year into our
initial investment, it has lost -60% of its value as they heap on debt and issue ever more
shares of stock with their acquisition binge. Chances are not insignificant it could be
worthless and I will be writing about it in the Mistakes section of a future letter. And yet,
there are enough flickering signs of hope that I am not ready to give up just yet,
especially since it is our smallest position so even a total loss wouldn‘t really move our
needle. Should ―Daphne‖ pull through though, it could reward us with a needle moving
3-4x return.

 Dillards (DDS) is an American department store company I previously invested in in

2014 when we briefly rode its shares from ~$90 to ~$110. Since then, Amazon has laid
waste to brick-&-mortar retailers all over, and Dillards was no exception. DDS, after

17
As a fun aside, Charlie Ergen’s neighbor in Denver, Dr. John Malone, famous for being one of the founding
fathers of cable and current chairman of the spaghetti of Liberty holding companies that control Charter
Communications, is widely worshipped by the investorati for his brilliance and vision and wealth creation. Few
realize that Mr. Ergen, as his peer in the telecom space who essentially bootstrapped his satellite TV business
and who garners much less attention, is actually far wealthier.

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reaching $140 in early 2015, crumbled below $50 in May 2017, where I decided 4x free
cash flows is cheap enough for another go ‗round. In contrast to its department store
brethren, e.g. JCP, M, JWN, etc., its main attractions are: 1.) relatively low levels of debt,
2.) relatively high ownership of its underlying real estate, 3.) owner-operated and
controlled by the Dillards family who, together with its employees‘ 401(k) plan, own
almost 50% of all shares outstanding, and 4.) voracious buyers of their own stock,
having repurchased almost 40% of shares outstanding over the past five years, entirely
funded by free cash flows. With DDS trading at 4x FCF, simply buying back shares
achieves an ROIC of 25%. The bet here is on management rationally allocating capital by
pruning underperforming stores and continuing their relentless repurchase of shares.

Mistakes

Dillards was not the only adventure I attempted in retail land last year. CBL & Associates
Properties (CBL), a mall REIT18, found its way into our portfolio at the same time.

I have a high level of conviction that the brick-&-mortar retail complex as a whole is mispriced;
the difficulty lies in determining which ones will survive, which ones will thrive, and which ones
will die. Of the three, the thrivers will produce the most immense returns for those that are
brave (or lucky) enough to invest today. I believe Dillards is a survivor, but CBL, on the other
hand, has a chance to be a thriver. As a mall REIT, they are essentially landlords, and yes, malls
are in trouble, but the beauty about being a landlord is you can make wholesale changes. Out are
the enclosed spaces, in are the open-air ―town centers‖ anchored by movie theaters and fitness
centers and restaurants. This model works. Amazon may be eating the world, but people will
always want to go out and mingle and gossip.

The ultimate fate of CBL is still to be determined, but by December, I sold out for $5.90 per
share on a cost basis of $7.84, a -25% loss. Fortunately, it occupied just 1% of our portfolio. My
mistake here was not that my analysis was wrong – it‘s that I didn‘t do enough analysis in the
first place before entering into this position. I caught wind of this idea from some outside
sources whom I respect and quickly jumped in after only superficial due diligence of my own,
rationalizing that I am piggybacking on hours and hours of existing research from people I know
who do good work.

This is not an indictment on their diligence (which I still consider to be excellent), but rather, on
my process, which when I ―outsource‖ research in this manner, do not afford me a level of
conviction that girds me to hold through volatility, especially in as precarious a space as retail in
this current environment. Watching CBL drop from $8 to $5.50 in a week was paralyzing. If I
had done the work, perhaps I would have the conviction, even enthusiasm, to buy more, but alas,
the dominant voice in my head was doubt. I sold in the name of generating some tax losses and
vowed that this time, I will do the work. which continues to be in progress.

18
REIT = Real Estate Investment Trust, a legal structure that requires passing through 90% of profits as dividends.

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A Look Back and A Look Ahead

Incandescent Capital has now capped off five years in existence. Our ~23% gross return in 2017
and ~17% annualized since inception is a decent but dampened achievement in light of the S&P
500‘s comparable rise. More notable is that we were able to achieve our gains idiosyncratically,
generally focusing ~50% of our investments in just a half-dozen securities, none of which in the
past couple of years belonged to the top 25 performers of the index nor the FAANG19 gang. An
element of my value to you is thus exposure to the contrarian and/or obscure – your wealth is
diversified away from not just the general market but also popular stocks that you can easily buy
should you be inclined to play the market yourself.

Sentiment around many high-flying stocks like the FAANGs and their ilk is that they are so
dominant in their respective industries, so large, and suck up so much top talent that at
whatever valuation they are bid up to, they‘re worth it because they will inexorably grow into it
over time. These economic arguments are not irrational, and with their double digit growth rates
in an era of low interest rates, there is even a mathematical argument to be made that they are
literally invaluable20.

A note of prudence, however: history has seen such a phenomenon before, and I am not talking
about the housing crisis nor even the dot com bubble. In the ‗60s, the U.S. economy entered into
a period of growth and optimism fueled by the country‘s emergence as a world superpower. The
corporate titans of the time like McDonald‘s, IBM, Avon, Polaroid, Xerox, etc. were coined the
Nifty Fifty and were considered no-brainer blue chips that deserved unlimited premium. Such a
sentiment lasted for years, with each passing annum of ever increasing stock prices serving as
evidence of some newfound physical law of the universe: ―Just buy IBM. It will never go down.‖

Stocks, of course, always go back down at some point. The law of gravity trumps all. The world is
chaotic, unpredictable, messy, greedy, vicious. In 1973, the Dow peaked at 1,052 and that peak
was not to be seen again until… 1982. Almost every Nifty Fifty stock declined 50+% from peak to
trough as America succumbed to recession, war, an impeached president, inflation, and an
energy crises. The earlier euphoria gave way to one of the worst bear markets in history: an
utterly lost decade.

Our collection of businesses, on the other hand, is a motley crew of obscure, unloved, and/or
misunderstood underdogs who are making money for us while others get the glory. Our
management teams are comparatively old fashioned. Their uniform is business-casual, not
hoodies; dress shoes, not Allbirds21. They tend to prioritize profits and cash flows and under-
promise but over-deliver. These are people we want to be in the trenches with day in and day out.

19
Facebook, Amazon, Apple, Netflix, Google  F.A.A.N.G.
20
One method calculating the terminal value of a Discount Cash Flow model is the perpetuity growth methodology,
where if the growth rate is greater than the cost of capital, it results in a terminal value that is effectively infinity.
21
“To Fit Into Silicon Valley, Wear These Wool Shoes”: https://www.nytimes.com/2017/08/11/technology/allbird-
shoes-silicon-valley.html

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***

Looking forward on a macro level, the crystal ball remains as murky as always. The S&P 500 has
been a most difficult opponent for active managers over the past eight years, and there are now a
whole class of millennial financiers who have never experienced a meaningful drawdown, much
less a bear market. An unscientific survey of a few peers as well as anecdotes gathered from
general news clippings suggest even the most hardy bears have scaled the wall of worry and now
harbor great expectations for 2018 and beyond driven by tax cut euphoria and deregulation.

Color me cautious. I am prepared to suffer some cash drag and moderately underperform a
roaring market as to be willing and able to strike when called for. As Warren Buffett wrote in
Berkshire‘s 2016 annual letter, ―Every decade or so, dark clouds will fill the economic skies, and
they will briefly rain gold. When downpours of that sort occur, it‘s imperative that we rush
outdoors carrying washtubs, not teaspoons.‖

As the Omahaian Oracle commands, so your humble investment manager will build washtubs
and await the deluge.

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 2018.

Sincerely,

Eric Wu

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