I

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February 6, 2015
Dear Investori:
Our portfolio rose 1.46% in December of 2014 versus the S&P 500s decline of -0.25%, bringing
our full year (unaudited) return to 5.31%. This compares to the S&P 500s gain of 13.69%. The
table and charts below include other performance figures:
Incandescent

S&P 500

Difference

5.31%
69.21%
30.08%

13.69%
50.42%
22.65%

-8.38%
18.79%
7.43%

2014 Year to Date

Since Inception (24 Months)
CAGR

Last 12 Monthly Returns

12.00%
10.00%
8.00%
6.00%

4.00%
2.00%
0.00%
(2.00%)

Jan

Feb Mar Apr May Jun

Jul

Aug Sep

Oct

Nov Dec

(4.00%)
(6.00%)
Incandescent

S&P 500 Total Return

Returns Since Inception

Incandescent

S&P 500 Total Return

Jan-13
Feb-13
Mar-13
Apr-13
May-13
Jun-13
Jul-13
Aug-13
Sep-13
Oct-13
Nov-13
Dec-13
Jan-14
Feb-14
Mar-14
Apr-14
May-14
Jun-14
Jul-14
Aug-14
Sep-14
Oct-14
Nov-14
Dec-14

80.00%
70.00%
60.00%
50.00%
40.00%
30.00%
20.00%
10.00%
0.00%

40 Fulton St, 20th Floor New York, NY 10038 646-912-8886 www.incandescentcapital.com

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Although Incandescent Capital was only officially launched 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:

2009
2010
2011
2012
2013
2014
CAGR

Return
50.75%
18.78%
2.28%
16.38%
60.68%
5.31%
23.84%

S&P
26.46%
15.06%
2.05%
16.00%
32.31%
13.69%
17.20%

Difference
24.29%
3.72%
0.23%
0.38%
28.37%
(8.38%)
6.64%

HFRX1
13.40%
5.19%
(8.88%)
3.51%
6.72%
(0.58%)
3.00%

Difference
37.35%
13.59%
11.16%
12.87%
53.96%
5.89%
20.84%

And here is how $100,000 would have compounded versus those two benchmarks if it was
invested at the end of 2008:
$400,000

$360,643

$350,000
$300,000

$259,098

$250,000
$200,000
$150,000

$119,372

$100,000
2008

2009

2010

Incandescent

2011
S&P

2012

2013

2014

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 2014, if you elected our standard 20% performance fee (no hurdle, no management fee)
arrangement, your net return would be around 4.25% compared to your gross return of 5.31%.
Also, depending on when your account was on-boarded, your results may differ from the main
reference account reported above. It takes a bit of time to sync each account to the same
exposure as I buy/sell according to the ebb and flow of the market. As always, your patience is
asked for as I build your new portfolio up, but rest assured: what you own, I own. I am
committed to eating my own cooking2.

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

The main reference account statement is available upon request from any investor.

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Contents
2014 In Review .................................................................................................................... 4
A Sense Of Permanence .............................................................................................................. 5
The Worlds Greatest Stock Picker ................................................................................................ 6

Yellow Media Limited ......................................................................................................... 7

United Insurance Holdings ................................................................................................. 8
Billy ................................................................................................................................... 9
Special Situations .............................................................................................................. 10
HC2 ............................................................................................................................................... 10
Sidebar: Buffetts Cocoa Bean Arbitrage ................................................................................ 11
Metro Bancorp .............................................................................................................................. 11

Cash Proxies ...................................................................................................................... 12

Mistakes ............................................................................................................................. 13
A New Hope, Revealed ...................................................................................................... 15
Outlook .............................................................................................................................. 16

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2014 In Review
Here are how our positions look as a percentage of total portfolio and its geographic split:

Position Size by %

20.6%

Geographic Split

14.6%

16.0%

10.6%

9.4%
8.9%

84.0%

8.5%

Cash

Canada

USA

As of the end of 2014, cash (that lime-green beveled slice) was 20.6% of our total portfolio, our
biggest position. Our biggest non-cash position accounted for 14.6%, and our top five noncash positions occupied 52% of our total portfolio.
In the light of conventional asset management dogma, we've had a mixed year. We trailed the
S&P 500, but we beat the Russell 2000 small cap index (whose members constitute the majority
of our fund 3) and the HFRX Global Hedge Fund index. Notably, we generated our returns
holding above average amounts of cash, a tactic I do not regret given the limited investment
opportunity set currently presented by the market.
As Ive written in several letters throughout the year, the S&P 500s performance can be a
misleading indicator of economic health and confidence. Investors bid up large caps far in
excess of small caps, a sign of fear and a decreased appetite for risk. The indexs slow grind
upwards was punctuated by several episodes of extreme volatility, bringing to mind a game of
musical chairs whereby once the music stops (i.e. the markets uptrend is broken), traders
scramble for an open chair (i.e. the sell-sell-sell button). Interest rates on the 10-year U.S.
Treasury Bond, predicted by the vast majority of experts to rise by the end of the year, instead
declined from 3% to 2%. Ask yourself, if the global economy is on such solid footing, why would
anyone accept a 2% return for 10 years?

Some have questioned why I insist on comparing our numbers to the S&P 500 when arguably our portfolio
constituents more frequently come from the Russell 2000. The reason is most of Incandescent Capitals investors
would probably be putting their capital into SPY or a low-cost index fund that replicates the S&P 500 if they did
not choose to invest in me (and it is what I would suggest to them as well). The more sophisticated investors
can easily compare my numbers to whatever benchmark they desire.

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It was a strange year indeed, one which featured conflicting signals and dead-wrong
expectations from the experts. So much so that financial commentator Josh Brown ran a piece
in Fortune titled 2014: The year that nothing worked4:

Utilities, a sector that underperforms during periods of rising interest rates and
economic growth 5 , instead outperformed and returned 23%, second only to the
healthcare sector (another defensive sector). Yet, every single Wall Street economist had
called for higher rates at the start of this year and 67 of 67 economists surveyed by
Bloomberg concurred.

Rounding out the top-performing sectors of 2014 was an unlikely pair: tech (+16%) and
consumer staples (+13.2%)the most aggressive and most defensive areas of the market,
running side-by-side toward the finish line, with confounded spectators struggling to
concoct a narrative for this. Why would the least cyclical sectorshealthcare, staples and
utilitieslead the markets in a year in which unemployment plummeted and GDP
growth gained momentum?

Only 30% of S&P 1500 stocks posted gains exceeding the index itself. Youd have to go
back to 1999 to see anything like this.

A Sense Of Permanence
None of the above should be interpreted as an excuse for us lagging the S&P. Bluntly, our
returns last year was dissatisfying. However, you may remember my annual letter last year
wherein I laid out my primary long-term goals for Incandescent Capital:
1. Do not lose money
2. Outperform during bear markets
3. Outperform over a multi-year horizon
The critical definition to grasp is long-term. If there is one aspect of my investment process that
has evolved, it is an ever increasing focus on looking many years ahead. It means when I invest
in a security, unless it is a special situation with defined catalysts happening within a specific
time range or a piece of distressed debt with a fixed maturity, I am anticipating our likely
holding period to be multiple years with the hypothetical intention of possibly forever. It is what
Lawrence Cunningham calls a sense of permanence6, a phrase he uses to describe how Buffett
has built Berkshire Hathaway to endure long after his own lifespan.
Truly long-term thinking is a novel concept. Wall Street, to the contrary, insists on judging on
much shorter durations. Quarterly reports. Monthly numbers. Daily P&Ls. Fundamentally,
there is no difference between a privately held business versus a publicly traded one... except the

http://fortune.com/2014/12/24/investing-year-review/

Why? Utilities are regulated enterprises with monopolistic earnings power and typically provide stable dividend
checks to investors. That makes them bond surrogates. And bond prices go down when interest rates go up.

http://www.valuewalk.com/2014/10/berkshire-beyond-buffett-book/

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value of public companies fluctuate by the nanosecond. Trading activity has increased to
ludicrous levels of fury, and almost completely controlled by computers to boot. It is, of course,
nonsense. Businesses take time to execute strategies, to hire people, to accumulate working
capital, to close sales, to build a reputation and a brand. To judge a business on how its stock
writhes and twists under the control of competing computer algorithms is obviously folly. And
yet, our emotions rise and fall commensurate with how our stocks wiggle up or down. We simply
cannot help it.

The Worlds Greatest Stock Picker

Last October, Barry Ritholtz published a column in the Washington Post7 with this tantalizing
lede:
Lets imagine for the moment that you are the Worlds Greatest Stock Picker. You have
an uncanny talent for ferreting out the next Microsoft companies that are on the
sharpest edge of whats next, that are about to undergo tremendous growth.
Using the five most well-known stocks that have returned over 1,000% to-date since their IPOs
as an example, Mr. Ritholtz takes us on a trip down memory lane. Remember when: Netflix lost
41%... in one day? Chipotle lost 76% during the Great Recession? Apples stock got cut in half in
one quarter? In one month? In one week? All true stories. How many of us could stomach that
level of volatility and actually reap the 1,000% return, even if we could identify those incredible
stocks in the first place?
The rejoinder: Your superpower gives you the ability to find the giant winners, but it does not
give you the ability to hold onto them. It is a brilliant piece that suggests perhaps the true
superpower then lies not in stock picking but in the ability to endure the nonsensical volatility
that surround the public markets, to abide by the fundamentals of the business, to keep ones
vision on the long-term.
And so it is from this perspective that we should use to judge our results. Instead of just looking
at how our stocks performed in the market, which, as Keynes has quipped, is basically like a
beauty contest, we should ask questions like: How did our businesses operate over the course of
the year? Did their earnings power grow or shrink? Did they maintain the value of their assets?
Are they taking undue risk with their balance sheet? Did their managers allocate capital in a
responsible manner?
In that context, I am much more sanguine about 2014. I made mistakeswhich I will openly
discuss later onbut none that did permanent damage. All of the names in our portfolio
continue to check yes to most of those questions above. Some of their stock prices moved to
reflect that, and some did not. Most importantly, I have developed several new ideas that should
bear fruit for us in 2015 and beyond.
Now lets talk stocks.

http://wapo.st/1vjFMik

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Yellow Media Limited

For the second year in a row, I will begin by talking about Yellow Media (TSE: Y). In 2013, it
was our banner success story. Now, in 2014, I can report weve booked most of the profits, the
majority of it being the more favorably taxed classification of long-term capital gains. Owing to
the fact that it tripled in 2013 and ended up as such a big position in our fund (approximately
40%) as well as for tax management purposes, I decided to sell gradually over the course of the
year. We sold over half in Q1, and then another quarter in Q2, and finally the rest in Q3.
There are several items to discuss involving such a timing and rationale. First of all, you should
know that our weighted-average cost basis was $8.11 and our weighted-average sale price was
$20.40. We didnt quite book the full triple, but a 2.5x return in two years on our biggest
position by far should still be enormously satisfying.
This affected our performance for the year because Y, which started the year at around $20,
spent nearly the entire year pulling back to $14 before rebounding back to the $17 range by yearend. For investors that came onboard in the first half of 2014, that was an unfortunate headwind
to contend with. It was an admittedly thorny issue one always hopes to make a good first
impression, but sometimes the market does not cooperate. The best I could do was to constantly
keep communication lines open and explain my rationale in real-time.
Obviously in hindsight I would have loved to have sold the entire position at its $25 per share
peak in February and immediately rotate the cash into our next best-performing idea. But
executing perfect timing in the stock market is a unicorn. The fact of the matter is Y is still a
cheap stock. It continues to trade at single digit multiples while its digital business has officially
crossed the 50% revenue threshold. Those factors alone make a good bull case for the stock even
at $20 per share.
However, the story is becoming complex. What was once a no-brainer strategy of shoveling free
cash flow towards debt pay-down is now muddied by their attempt to accelerate digital growth
by spending heavily on marketing while pulling back on reducing debt. Time will tell if their
strategy bears fruit. The plan is a long one and does not forecast overall growth until 2017. I
believe current management has their heart in the right place, but it will be difficult to grab
mindshare from the new internet darlings and whatever grounds they gain with their marketing
push will not be as defensible as it was in the days of the monopolistic yellow pages.
As such, my preference would be for Yellow Media to continue to aggressively pay down debt. A
bird in the hand is worth more than two in the bush in this case. Still, we have retained a small
percentage of our fund in Y warrants as a way to express my ambivalence. I hope they succeed
and will stand to benefit some if they do, but if they do not, we will not be significantly hurt
either.

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United Insurance Holdings

Our biggest contributor of 2014 was a name I alluded to in my July letter in a section titled A
Live Case Study of Short-Term Market Irrationality. Brief recap: United Insurance (UIHC)
is a Florida-domiciled Property & Casualty (P&C) insurance company specializing in catastrophe
risk. The company was founded in 1999 to take advantage of the Florida P&C market which was
then dominated by the state-operated Citizens Property Insurance. Political pressure forced
Citizens to begin to divest insurance policies at attractive economics to private insurers like
UIHC, a process coined take-out.
Fundamentally, the company has been on a tear. They have begun aggressively expanding their
coverage to coastal states from Texas to Maine. It has been an extremely successful campaign,
more than doubling their policies in-force and compounding their book value by 15+% per
annum since 2011. What separates them from their fellow Citizens take-out competitors is their
focus on building a quality network of agents and growing organically outside of Florida. 79% of
their Q3 growth in premiums came from outside the sunshine state.
Although weve held a position in UIHC since mid-2013, initiating our position around $7 per
share, short-term market irrationality in July (and later, September) gave us an opportunity to
add to it. Despite stellar earnings, the stock sold off. There was no rational reason. Insiders even
stepped up to buy shares in the open market. As I wrote in the July letter:
Such is how irrational Mr. Market can be at times, and it is easy, even instinctive, to feel
fear in the face of a rapidly tumbling stock price. But for those who have done the
homework and possess the confidence gained through careful and thorough due
diligence, fear becomes opportunity. We upped our position in this company the next
day, which, unfortunately, make our monthly statements look bad, but has a very
probable chance of being highly profitable over time as the company continues its
upward trajectory.
We scooped up shares between $14 and $15 as did opportunistic insiders who were just as
baffled. In hindsight, it was a layup scenario. As management keeps hitting their numbers and
the value of their business rise, the market was, astonishingly, offering us an even bigger
discount. Im happy to say UIHC closed just shy of $22 at year-end. We continue to be very
satisfied shareholders and hope to be for years to come.

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Billy
Our second biggest contributor is a Canadian alternative energy company which I will demure
from revealing for now8. This company, which Ill call Billy, has been a staple of our portfolio
for over two years and exhibit characteristics that Buffett uses to describe an ideal business: One
that earns very high returns on capital and keeps using lots of capital at those high returns.
That becomes a compounding machine.
Billy has a long history which began as the energy arm of a manufacturing company. Over the
years it sharpened its focus on sustainable renewable energy and today own a portfolio of mostly
wind and hydro power stations. Why is this an ideal business? Because Billy has relationships in
jurisdictions that have favorable public policies towards green energy. That means their power
stations sign long-term (think 15 to 30 years) contracts with AAA-rated utilities locking in a high
enough price-per-megawatt-hour to earn a high return on their capital. They can do this over
and over again because the world has a long way to go to wean itself off of fossil fuels.9
Traditional by-the-textbook investors tend to quickly pass on the name when they look at their
financials: thin profit and free cash flow margins, highly levered. Such an assessment is a
fundamental misunderstanding of Billys business. Profit margins are thin because depreciation
is the biggest cost even though wind and hydro plants require minimal capex to maintain.
Leverage looks high but the debt is owed by each individual power plant (which is backed by
guaranteed contracts), and thus is non-recourse to the parent company. Free cash flow looks
putrid but thats because all the free cash is busy being spent on new projects that will spew out
even more cash.
The key metric to assess here should be operating cash flow, which reflects how productive
and valuable their growing cadre of assets are. Most investors do not realize that Billys business
is comparable to a real estate investment trust or an expanding telecom company. All of these
businesses require high up-front capital expenditures but then much less to maintain once the
assets are constructed. The assets are valuable and cash generative and the high depreciation
shields much of the tax liabilities in the early years.
Billy is relatively illiquid due to the aforementioned manufacturing company who still owns over
30% of the company. Also, it trades on the Toronto Stock Exchange. Those two characteristics
keep the stock relatively off the radar of most investors and consistently cheap. That is totally
fine by us. We do not need investors to wake-up and realize how valuable Billy is. If they do,
well probably reap a considerable immediate windfall. But if not, their asset base will continue
to compound and their cash flows will continue to increase, and the stock, even while staying
cheap, will continue to inexorably advance:

Why? Its complicated. Call me if you want to know the details.

Buffett knows this. His Berkshire Hathaway Energy group has invested over $15 billion in renewables and hes
been quoted saying: Theres another $15 billion ready to go, as far as Im concerned. Its where the countrys
going. http://cleantechnica.com/2014/10/12/warren-buffetts-midamerican-energy-investing-280-millioniowa-wind-farms/

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3 year chart of Billy, a boring but steady compounding machine

Special Situations
Occasionally we will invest in special situations companies that are undergoing some form of
corporate change unrelated to normal business activities. These special situations are by nature
short-term, with defined catalysts and rough timeframes in which they will (or will not) resolve.
Here is a tale of one successful, and one not-so successful special situation investment we made
last year.

HC2
In Q3, a popular write-up was passed around the investment community regarding a
construction company called Schuff. Schuff had been a family-run business for years and years
and could barely be thought of as public. It traded on the pink sheets 10 and 65% was held by
insiders who never traded their shares. Then, in May, Schuffs biggest shareholder, Scott Schuff,
decided to sell. A deal was struck with HC2 (HCHC), a shell company owned by New York
financier Philip Falcone, to acquire his shares. HC2 proceeded to make a run at the rest of the
shares via a tender offer for $31.50 per share.
The popular play at the time was part arbitrage, part activist. Buy up shares of Schuff and force
Mr. Falcone to pay a higher price. By many metrics, it seemed like Mr. Falcone was stealing
Schuff. Construction is a cyclical business and Schuff is on the uptrend of the latest boom.
However, Schuff was extremely illiquid. Few, if any, shares were readily available on any given
day. A much easier trade, it occurred to me, was to simply buy HC2. It was also pink sheet
traded but was much more liquid. Instead of scraping for shares of Schuff and hoping to force a

10

i.e. Not on any major exchanges and only through participating market makers, a.k.a. Over The Counter (OTC)

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higher tender offer, why not simply switch teams and own HC2? You get better economic
benefits than owning Schuff due to the NOLs HC2 has stashed away11, and then further technical
upside if HC2 uplists to a national exchange and improves their visibility to mutual funds and
other large investors.
We bought shares of HCHC at around $4. By October, Falcone successfully squeezed out the rest
of the shareholders and completely took over Schuff and HCHC traded up to $5.50 per share.
Then the company announced they are uplisting to the New York Stock Exchange and shares
reached $8. We exited this trade at $7.66 in December, banking quite the IRR for our buck.
Sidebar: Buffetts Cocoa Bean Arbitrage
Our HC2 trade was inspired in part by the story of when Buffett was a young man and
worked for his mentor Ben Graham. Graham had come upon a situation where a
company called Rockwood was trading its inventory of cocoa beans for shares of its
stock. To incentivize the trade, Rockwood offered $36 worth of cocoa for $34 worth of
stock, a surefire way to bank $2 per transaction. Buffett managed this near risk-free
trade for Graham but for himself, he bought shares of Rockwood and just held on to
them. He correctly figured that if Rockwood was so desperate to do this trade, the true
upside was in actually owning the company rather than the cocoa beans. And guess
what? Rockwood shares went from $15 to $85. It was an extraordinary example of
inverted, simple big picture thinking that eludes even the most intelligent of investors
who can be seduced by fancy complex situations that offer only limited upside.

Metro Bancorp
Our less-than successful special situation is not nearly as complex. In June, we initiated a
position in a community bank holding company called Metro Bancorp (METR) at around
$22-$23. Metro was a former franchise of the successful Commerce Bank (now owned by TD
Bank), whose model was unprecedented levels of customer service. Walk into a branch and be
greeted as a guest rather than a customer. Free candy and coffee while you wait for a
representative. Open 7 days a week. Customers loved it and poured deposits into the bank,
creating an enviable core deposit base that basically amounted to extremely cheap money for the
bank to lend out.
However, we no longer live in a world where such a model is as attractive due to the financial
crisis and the proceeding low interest rate environment. Banks can no longer lend at high
enough interest rates, nor an aggressive enough leverage ratio to offset fixed costs such as fancy
branch service and generate an acceptable ROE for their shareholders. Several activist investors
piled into Metro and began clamoring for a sale of the company to a bigger bank who can better
leverage their attractive core deposit base.
The bet was simple. If the activists succeeded in completing a sale, we would have a nice windfall.
If they dont, we exit with hopefully minimal losses. My research indicated there were interested

11

NOL = Net Operating Losses, which are tax shields from losses generated by the old business

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suitors for Metro, with the only question being whether its management would be willing to
maximize shareholder value or would rather hold on to their jobs and continue to enjoy their 36-3 lifestyle12. By October, we had our answer: the latter. As a token compromise, management
offered to initiate a small dividend and share buyback program and promised to cut costs. The
activists were not pleased and is seeking to infiltrate Metros board. Anyway, thats not what we
signed up for, so we exited shares at $23.16 for, luckily, no loss whatsoever.

Cash Proxies
In last years letter I talked about the idea of cash proxies securities that I deem safe enough
to park our excess cash and are liquid enough to trade out of should a better opportunity
suddenly present itself. Cash proxies typically have some traits that make me believe their
downside, even in the short to medium term, is limited.
Dillards (DDS) was an early name we rotated some of our Yellow Media profits into. For most
of the 2000s, Dillards was an underperforming retailer with undifferentiated offerings and
gaggle of underperforming stores. After the Great Recession, management got religion and
cleaned up its basic business fundamentals better inventory management, shut down
underperforming stores, improved working capital, etc. Most remarkable was what they did with
the sudden growth in excess free cash flow: they bought back stock. From 2007 to 2013, share
count was reduced from 79 million down to 46 million, a reduction of 42%.
Whoever believe share buybacks are useless never invested in DDS because the stock went from
$4 in 2009 to over $100 in 2014. Thats a 25x return a 70% CAGR, folks! from a sleepy
department store with no presence in L.A., San Francisco, Chicago, or New York that shrank its
footprint during that time frame! We caught the tail-end of that run after management
announced (surprise surprise), yet another share buyback, and rode DDS from $90.72 to
$109.70.
Supremex (TSE: SXP) was a tip I got from Guy Gottfrieds presentation at the 2013 Value
Investing Congress13. The company is the largest manufacturer of envelopes in Canada. Plainly,
a dying business. But as Howard Marks often said, there are no bad assets, only bad prices. And
SXP sported a very nice price indeed: 4x free cash flows (FCF) and a 7% dividend yield that
represented only 25% of its FCF. Basically, it was trading at a price that would be overwhelmed
by its free cash flows in just a few years. Scenarios like Supremex, however, can become value
traps if management is filled with the illusion that they can turnaround the business by
investing in growth. Luckily, adult supervision was present in the form of Clarke Inc, an
investment holding company controlled by savvy investor George Armoyan which owned 45% of
SXP. We initiated a small stake (perhaps too small) at $1.80 and exited at $3.04.

12

An old banking joke: borrow at 3%, lend at 6%, hit the golf course by 3pm.

13

Long-time readers will recall we also plucked an idea from Mr. Gottfried in 2012, The Brick, which also doubled.
At this point, whatever Mr. Gottfried publishes, I make sure to take a long, hard look.

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Our final cash proxy was mentioned in my August letter Apple (AAPL). While typically
mega-cap companies are not where one would likely find inefficiencies to exploit, Apple is a
unique stock due to its mystique and the fact that everyone has an opinion on the company. Do
you remember AAPL being nearly cut in half from late-2012 to mid-2013? That typically do not
happen to efficient stocks with hundreds of billions in market cap. However, similar to
Dillards, management got religion with regards to capital allocation. Its dividend was raised,
and titanic share buybacks were announced. In May 2014, CEO Tim Cook anticipated returning
$130 billion to shareholders. Those are record breaking figures, and it telegraphs the fact that
Apple will be aggressive with regards to buying its own shares in the open market. Basically, a
floor for the stock was put in. We started buying shares around $86 and sold them at $96 a few
months later when more attractive opportunities presented themselves.

Mistakes
Mistakes are inevitable when investing. Thats because investing is, at its essence, an attempt to
predict the future. For stocks, were trying to guess at future cash flows, which depends on
industry dynamics, management, financial health,. etc., and compress all that information into
one number: the stock price. This is not a game anyone gets right. This is a game of odds.
Two mistakes stood out last year. The first with which I will flagellate myself with is Roundys
(RNDY), a grocer in Wisconsin and Chicago that, in hindsight, fits into the old Charlie Munger
aphorism: if you mix raisins with turds, you still have turds. This was a clear unforced error by
your humble investment advisor. Roundys has a long history as the dominant grocer in
Wisconsin. They were taken private in 2002 by Willis Stein & Partners and re-IPOd in 2012 to
much ado about nothing. RNDY had hoped to open between $10-12 per share but instead
printed at $8.50.
Roundys had several things going for it that attracted my interest. 1.) A busted IPO typically
leaves behind disillusioned investors and a depressed stock price fertile hunting grounds for a
value investor. 2.) Bob Mariano was brought on by Willis Stein to be CEO. Mr. Mariano had a
distinguished career at Dominicks, eventually selling it to Safeway in 1998 for $1.2 billion. 3.)
Mr. Mariano began to launch a new store brand in the Chicago area called Marianos which, by
all measures, is a major success and has a long runway for growth. I began to draw parallels to
Mickey Drexlers career arc, who came to fame by growing The Gap and returning for an encore
with J. Crew, a successful investment of ours in 2010.
The stock was cheap because even though Marianos was doing gangbusters, their legacy
Wisconsin stores, suffering from years of under-investment, was getting their lunch eaten by
competitors. However, I calculated that RNDYs valuation had it fully discounted it could be
argued that Marianos is worth the entire market cap of RNDY alone. Mr. Mariano has
continually promised to turn Wisconsin around. If Wisconsin stabilizes, RNDY could be an easy
double from our cost basis of around $7.
Unfortunately, quarter after quarter, Roundys missed their numbers. It was comical in a sadclown kind of way. It became clear that management was really only interested in Marianos

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growth in Chicago. When Safeway announced they were divesting a bunch of old Dominicks
stores, Roundys issued expensive debt and equity to buy them up and convert into Marianos.
Meanwhile, their comparably generic Wisconsin stores languished. Same store sales continued
to decline and eventually dragged what was once a profitable, dividend-paying enterprise into
the red ink of quarterly losses. Their CFO quit for a better opportunity at Rite Aid.
While its still possible the rapid growth of Marianos in Chicago could pull Roundys out of its
tailspin, I threw in the towel in June, selling our shares around $5. Perhaps there will be a way
to isolate the Mariano stores from the declining Wisconsin stores perhaps through a sale,
although it seems unlikely because why buy up your competitor when you can just compete it
out of existence? but the bond holders will be ahead in line to capture the value. When you
mix raisins with turds, you still get turds indeed.
The other mistake is Danier Leather (TSE: DL), a small Canadian retailer that practiced
excellent capital allocation but did not move fast enough into the internet shopping and big data
era. Danier is an old idea that was already part of Incandescent Capitals portfolio before I began
taking outside investors. We began building the position in 2011 and continued to peck at it
occasionally throughout 2012 and 2013. Our average cost basis was $11.45. The thesis behind
Danier was fairly simple. They occupied a niche with a relatively recognizable brand within its
market and its management has proven to be shareholder friendly in the past when they bought
back boatloads of stock during the Great Recession which propelled their stock from $3 to $14
per share between 2009 and 2011.
Unfortunately, Danier did not keep up with the times as consumers changed their shopping
habits. They werent equipped with proper analytics and ended up stocked full of unpopular
assortments. All the excess inventory over the holidays led to big discounts and crushed margins.
Its also likely that management overestimated their pricing power as consumers have grown
increasingly sophisticated by learning to price-check everything online. Speaking of online,
perhaps most damning was their lack of an eCommerce presence. As late as Q2 2014, they were
still relying on catalogs while trying to launch a workable eCommerce site. That strategic error
led to untold amounts of missed sales opportunities as a brutal winter encouraged most
consumers to shop from the comfort of their couches.
I sold out of DL at an average cost basis of $7.40. Looking back, there was little indication that
Danier Leather would end up this poorly. It was once a quality business helmed by managers
who owned tons of shares and practiced good capital allocation. But it was overwhelmed by the
tidal wave of change brought on by the digital era. Very few legacy retail companies has had the
foresight to shift strategically with enough speed. This was a defensible error but an error
nonetheless, i.e. its probable that mistakes like Danier Leathers will happen again in the future
the key is to not have it hurt too bad. In the latters regard, I did a passable job. Danier Leather
was kept at a relatively small size and the returns from our cash proxies over the years more
than offset the losses from DL.

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A New Hope, Revealed

In the New Hope section of my Q2 letter, I hinted that I found what I hope will be our next longterm winner. With a position fully built, I can reveal that it is BlackBerry (BBRY), currently
one of our largest holdings. We began buying in the $7s but have continued to accumulate as it
whips around and currently sit on a cost basis of $9.29 per share.
It is a turnaround play that is widely misunderstood. Like Apple, everyone has an opinion on
BlackBerry. The prevailing opinion continues to be that their handsets should be relegated to the
history books once iconic but, like Polaroid and Zip Drives, have no hope of capturing past
glory. Funny thing is, I actually agree with that assessment. What I disagree with is that fact will
doom the company.
BlackBerry has several key assets that are very difficult to replicate. One is their Network
Operations Center (NOC), which is essentially a global VPN hooked up to hundreds of wireless
carriers around the world. BlackBerrys NOC was originally built out to do a lot of the behindthe-scenes heavy lifting back when data transfers were very expensive. Today, its NOC is the
bedrock of its new pitch: security. Once a data packet is routed from the carrier into the
BlackBerry NOC, its effectively firewalled from prying eyes. By contrast, a regular cell phones
data packet would hop around various networks controlled by multiple entities before reaching
its destination. Its like getting into a bulletproof car you trust and driving to your destination
versus hitch-hiking your way there. These days, with reports of new corporate hacks happening
with increasing regularity, that trip is growing akin to traversing through Daesh-controlled
regions of Iraq.
Another asset is QNX (pronounced Q-NIX because its a Unix-clone). QNX was originally
acquired by BlackBerry in 2010 and its codebase was forked to build the operating system
running in the newest BlackBerry 10 handsets. It is a supremely stable OS because it is
microkernel based, meaning critical processes are run as siloed tasks and do not crash the entire
system if one of them misbehaves. This is an important difference because both Android and
iOS are run on versions of Unix (Linux and BSD, respectively) that are less stable (but more
efficient) monolithic kernels. Because of its stability, QNX has also been forked to become the
underlying OS that manages most of the software in modern cars. But wait, why stop there? Its
flexible microkernel architecture allows it to be customized for any connected object. As the
Internet-of-Things (IoT) phenomenon grow to link almost everything in our daily lives into the
cloud, expect QNX to play a significant role.
The crown jewel is their newly launched BES 12 enterprise server, a Swiss Army Knife solution
built to manage any and all handsets, including Android and iOS. This is a life-saver solution
for CIOs who are struggling with corralling all the personal mobility devices intruding into the
corporate LAN. Furthermore, BES 12 is the gateway to the BlackBerry NOC, which opens up all
kinds of possibilities that the company is just starting to explore. Example: VPN authentication.
No longer do employees need to lug around an expensive RSA tokens when traveling they can
simply authenticate their identity using their cell phone if its connected to BES 12 via the
BlackBerry NOC.

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Overseeing all of this as Chairman and CEO is John Chen, one of the most respected executives
in tech who was lured to the job by Prem Watsa when Watsas FairFax Financial led a group to
save the company with a billion dollar injection. Chens C.V. includes previously turning around
Sybase and generating a 28% CAGR over 12 years when it was ultimately sold to SAP. Chen also
sits on the board of Wells Fargo and Disney and is a trustee of Caltech and the think-tank
Brookings Institution and was senior advisor of $23 billion tech-focused PE firm Silver Lake
between his Sybase/SAP and BlackBerry gigs, et cetera, et cetera. The point is, John Chen has
been around the tech rodeo and, also, powerful people will return his messages.
I havent even mentioned BBM nor BlackBerrys patent portfolio nor their existing relationships
with 40,000 businesses around the world. The company today is so much more than a handset
maker. The crux of our investment in BBRY hinges on Chen tying all of those assets together and
transforming the enterprise into something like the Cisco of the mobile world, the guys who can
offer all the behind-the-scenes plumbing as more and more data travel across radio waves.
Those assets are real, even though traditional accounting cannot put a valuation on them, and
thus, BBRY continue to languish with a fraction of the enterprise value (which includes almost
$2 billion in net cash) afforded to tech companies sporting such treasure troves.
However, it is a volatile stock, popular with day-trading rumor mongers and the financial media,
and so I feel the responsibility to detail our ownership if/when it causes material ripples in our
monthly results. I believe time will monetize their assets, but if not, there are others who will
happily try as incessant rumors of big tech companies itching to scoop them up for cheap
circulates regularly. In a fire-sale scenario, BBRY shares are likely worth somewhere in the lowto-mid teens today. Thats the downside. As one big functional unit on the vanguard of the IoT
revolution, it could be worth multiples over time. We are rooting for a John-Chen-special 28%
CAGR over another dozen years.

Outlook
The bull market reached its sixth year in 2014 despite showing some noticeable cracks during its
ascent. It is my opinion that the broad stock market continues to be fully valued. The S&P 500s
forward P/E ratio has hit 16.6 times, which, according to FactSet, is its highest since 2005. Of
course, the interest rate environment today is completely different. My feeling can probably be
colloquially described as kind-of-expensive-but-not-insane. In other words, I have no idea how
the S&P will perform this year. I feel fortunate I am not a macro trader.
But as I review our overall portfolio, the phrase that leaps to my mind is: hard to lose.
BlackBerry is not yet at a size that disproportionately outweighs every other name, and I do not
anticipate building it to the size of Yellow Media back in 2013 because it certainly involves
execution risk. It can be thought of as a bundle of near-free call options that could be worth
multiples in the future while, buffeting its volatility, sleepy stable compounders like Billy and
UIHC and a couple of other undisclosed names round out our top positions.

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We remain relatively concentrated because, quite frankly, its tough to find good ideas. However,
literally 95% of my net worth is invested alongside yours, so constructing a portfolio that allows
me to sleep well while feeling excited about its prospects is my day-in-and-day-out obsessive
concern. That is one constant you can always count on. Investing is not just a job for me, it is my
raison d'tre and a wellspring of purpose and joy. I tap dance to work and feel humbled and
grateful to all my investors who enable me to do what I love every day.
As always, I welcome any questions and/or feedback. I wish you and yours a prosperous and
joyous new year.

Sincerely,

Eric Wu

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