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I NCANDESCENT C APITAL

February 9, 2017

Dear Investori:

Our portfolio rose 4% in Q4 of 2016 versus the S&P 500s rise of 3.83%, bringing our full year
(unaudited) return to 2.31%. This compares to the S&P 500s total return of 11.98%. The table
and charts below include other performance figures:

Incandescent S&P 500 Difference


2016 Year 2.31% 11.98% -9.67%
Since Inception (48 Months) 79.51% 70.82% 8.69%
CAGR 15.74% 14.31% 1.43%

Returns Since Inception

Incandescent S&P 500 Total Return

90.00%
80.00%
70.00%
60.00%
50.00%
40.00%
30.00%
20.00%
10.00%
0.00%
May-13

Jan-14

May-14

May-15

May-16
Jan-13
Mar-13

Mar-14

Jan-15
Mar-15

Jan-16
Mar-16

Sep-16
Jul-13

Nov-13

Jul-14

Nov-14

Jul-15

Nov-15

Jul-16

Nov-16
Sep-13

Sep-14

Sep-15

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%2 11.98% (9.46%) 2.50% 0.02%
CAGR 18.29% 14.44% 3.85% 2.08% 16.21%

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

$400,000 $383,374

$350,000
$294,141
$300,000

$250,000

$200,000

$150,000 $117,903

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

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 2016, if you elected our standard 20% performance fee (no hurdle, no management fee)
arrangement, your net return would be around 1.85% compared to your gross return of 2.31%.

1
This is the HFRX Global Hedge Fund Index, a widely used index to praise or pan hedge funds in the press.
2
Slightly different from the official time-weighted return of 2.31% due to me adding more personal funds in the
reference account in Q2.

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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 cooking3.

Portfolio Review

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

Position Size by % Geographic Split

15.3% 10.2%
16.5%

11.0%

9.6%

8.6% 89.8%
7.0%

Cash Canada USA

And heres a snapshot of where our investments fall into various types and sectors:

Investment "Type" Sectors


Special
Situations
10.5% Other,
Consumer 13.9% Tech,
Cyclicals, 24.8%
12.7%
Mispriced
48.0%
Compounder Energy,
41.5% 11.9% Financials,
36.8%

3
The main reference account statement is available upon request from any investor.

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As a reminder: Compounders are businesses I believe have long, predictable runways for
growth that weve 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, basic
materials, and industrial.
***

Despite a January that had us battling uphill for the balance of 2016, we managed to generate a
positive return in 2016 thanks to the rally in financial stocks in Q4. I use the word battle
metaphorically; as value investors, our battles are mostly inert and involve exercising patience.
Our portfolio turnover for the year was around 28% 4 . Our trading commissions paid as a
percentage of assets was 0.05%. Our realized (i.e. taxable) gains were between 20-30% of total
gains across all accounts. Rest assured our profits are not being siphoned away by brokers nor
market-makers nor the tax man.

In a low interest rate, low absolute return world, hidden costs matter more than ever. A major
part of my philosophy is to eliminate as many grubby middle-men as possible between us and
our profits. The concept is akin to how a widget manufacturer has to sell its product to a
wholesaler for, say, $10, who has to sell it for $20 to a distributor who has to sell it for $40 to a
retail store who has to sell it for $80 to you, the consumer. Remove several layers, and the
widget can be ultimately sold for far cheaper without sacrificing profitability. In investing, it is
done by cutting down on unnecessary fees generated by unnecessary trading, minimizing the
taxes by, ideally, compounding gains internally within the investee, and in cases of realized
profits, taking them at long-term capital gains tax rates.

Compared to the S&P 500, our slight outperformance in the second half of the year was not
enough to overcome our much wider underperformance in the first half. The year-end tally of
the S&Ps 12% total return vs. our 2.3%, however, does not constitute a tragedy. It is not the first
time we have underperformed and it certainly will not be the last. The process of patiently
collecting good businesses at attractive prices is a slow, bottoms-up affair and most of the time
the portfolio manager has limited ability to control the annual returns of the overall collection.
What matters most is the ability to stick around and fight another day. Long-term, our track
record remains, I believe, competitive, and more importantly, well-poised for the next five years
and beyond. Our portfolio now contains a collection of businesses that have the structural
wherewithal to withstand large unexpected shocks while also offering adequate returns and, in
the case of several, potential lollapalooza.

Lets talk about them in enthralling detail.

4
In other words, our average holding period, if we maintain a similar turnover ratio over time, is 3.5 years. For
contrast, the average turnover % for all mutual funds tracked by Morningstar is 72%, or an average holding
period of a mere 1.4 years.

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Table of Contents

BlackBerry ........................................................................................................................... 6

General Motors .................................................................................................................. 12

Banking & Insurance ......................................................................................................... 14

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

Atlantic Coast Financial ............................................................................................................... 16

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

Atlas Financial .............................................................................................................................. 18

United Insurance Holdings ......................................................................................................... 19

Heritage Insurance ...................................................................................................................... 20

A Quick Tour Of A Few Others.......................................................................................... 20

Billy ........................................................................................................................................... 20

Ricardo ...................................................................................................................................... 21

Calpine .......................................................................................................................................... 21

Dish Network ............................................................................................................................... 21

Daphne ...................................................................................................................................... 22

Mistakes of Omission ........................................................................................................ 22

Berkshire Hathaway ..................................................................................................................... 23

Advanced Emissions Solutions .................................................................................................... 23

VMware ........................................................................................................................................ 23

A Look Ahead .................................................................................................................... 24

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BlackBerry

For the past two and a half years BlackBerry (BBRY) has been our largest position. Its
negative performance in 2016 was the biggest detractor to our overall returns, contributing an
estimated -3.5% drag to our portfolio. However, it is still in the early innings of its new
incarnation as an enterprise software focused company; I remain optimistic in its prospects and,
in turn, our ultimate profitability in this name.

Given the size of this investment and its performance thus far, I feel its appropriate to spend a
disproportionately large chunk of time to rehash the history and thesis for your analysis and
judgment. Be assured that the rest of the letter will not be as loquacious.

BlackBerry, formerly known as Research In Motion, has a history that traces way back to 1984
when it was founded by a pair of engineering students in Waterloo Canada interested in wireless
technologies. For 15 years they toiled in relative obscurity, trafficking mostly in esoteric modems
and routers until they developed the first two-way pager capable of pushing e-mail to a mobile
device they called the BlackBerry 850.

Their rapid ascent thereafter fueled an explosive growth in assets, assets used to build a
manufacturing footprint capable of churning out millions of BlackBerries, and a secure Network
Operating Center (NOC) that connected to wireless carriers and facilitated all the data transfer
by compressing and routing packets. Thus, two streams of revenues emerged: 1.) from the sale of
smartphones, and 2.) from the Service Access Fees (SAF) the NOC commanded for its usage. Of
the two, the former got the headline glory, but the latter provided the true gravy for BlackBerrys
bottom line. Because each handset they sold generated a small SAF revenue per month, it
provided highly predictable cash flows with margins in the 90% range. At its peak in fiscal 2011,
SAF generated approximately $4 billion in almost pure cash flows.

This is a key insight. The true money maker in most tech enterprises is their high margin
software/services business. Software is akin to the razorblade versus the hardwares razor.

An important dynamic changed when the iPhone was introduced in 2007, and its not just how
revolutionary it was with respect to basically stuffing a Mac into a phone. It was the catalyst to
modernizing wireless infrastructure to enable not just voice and text messaging, but also large
packets of data necessary for true TCP/IP communication. In other words, the compression and
routing service BlackBerrys NOC provided was being obsoleted. Although AT&T ran into huge
congestion issues upon the launch of the iPhone, iterative improvements in 3G and then 4G
technologies proved the path forward was not compression of data but an expansion of the pipe
it traveled through. By 2013, wireless carriers no longer needed the services of BlackBerrys NOC
and negotiated as such for all future releases. Their cash cow SAF revenue line was officially in
run-off; to survive, management had to succeed selling hardware alone, which in hindsight was
as smart a strategy as well, trying to sell razors without razorblades.

The inevitable failure of BlackBerrys last home-grown operating system, BB10, precipitated the
current turnaround effort. Because the company had built such a large asset base dedicated to
manufacturing unwanted cell phones and providing unneeded data routing services, massive

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restructuring was required to pare their assets down to match the current business reality. In
2013, BlackBerrys largest shareholder Fairfax Financial led a consortium to inject $1.25 billion
into the company in the form of convertible debt. The board of directors and top management
were revamped, and keys to the kingdom were handed to then-58 year old John Chen.

As detailed my 2015 annual letter, management quality is the key consideration in a turnaround
situation. Mr. Chen has been in the technology business his entire career, starting from the
bottom as a systems engineer manning the overnight shift in mainframe server rooms. In 1993,
he turned around Pyramid Technology Corporation, which was one payroll from being insolvent
when he took control, and sold it to Siemens two years later. In 1997, he became CEO of Sybase
and turned a has-been database maker with a market cap of under $400 million that was getting
its lunch eaten by Oracle into a mobility pioneer that was eventually acquired by SAP for $5.8
billion in 2010 a 20+% compounded annual growth rate over 12 years.

Mr. Chens success has made him a wealthy and connected man. He sits on the board of Disney
and Wells Fargo and was Senior Advisor to private equity giant Silver Lake. He did not need the
BlackBerry gig and in fact turned down Fairfax head Prem Watsa several times before finally
saying yes. In the end, he took over BlackBerry for the same reason why Lou Gerstner took over
IBM in 1993 for the challenge of saving an icon. I once, about a year and a half ago, spent an
hour going through as many LinkedIn BlackBerry executive profiles as I could find, and counted
no less than fifteen ex-Sybase/SAP employees who signed on for another tour of duty with him.
Only an authentic leader could inspire his troops to abandon the job security provided by a
behemoth like SAP to climb onboard a struggling vessel like BlackBerry in late-2013/early-2014.
Our investment thesis would be moot if we did not have John Chen as our de facto partner
captaining this ship.

A painful restructuring commenced in 2014 that eliminated thousands of employees and saw
billions in inventory of unwanted BB10 phones written off. Fortunately, the SAF spigot,
although declining and in run-off, was still gushing hundreds of millions per quarter. That
provided a cushion and a runway for the turnaround to take hold a strategy to replace the
lucrative SAF stream with an equally lucrative software subscription revenue stream. BlackBerry
has always had a toehold in the software world with its BlackBerry Enterprise Server (BES) that
acted as the command and control center for IT departments deploying large fleets of company-
issued cell phones. It was a neglected corner of its erstwhile empire that Mr. Chen, with his
software-oriented background, worked to revitalize.

Here is key insight #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. Its one thing for a kid in a basement to write an app that goes viral; its a whole
different ballgame when software is powering mission critical functions. A not insignificant
investment must be made to build awareness, a sales force, relationships with thousands of
channel partners, and 24x7 support. This is why, to take a recent example, AppDynamics elected
to sell out to Cisco for $3.7 billion on the eve of its IPO despite its belief it can be a $10 billion

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company in the future5: its really hard to build that 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. Throughout 2014 and 2015,
in conjunction with building it out fully, they spent $800 million from their cash hoard to make
a string of acquisitions designed to bolster its software portfolio, the most important ones being
WatchDox (secure document sharing), AtHoc (mass communication), and Good (mobile
application management). Software revenues will have grown from $250 million in fiscal 2015
to, I approximate, $650 million by fiscal 2017 (end of February 2017)6.

(Table 1: BlackBerry Software & Technology Licensing non-GAAP revenues for last 8 fiscal quarters, in millions)

2015 2016 2016 2016 2016 2017 2017 2017


Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3
$74 $137 $73 $154 $153 $166 $156 $172

A fully functional, 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
(and thus, cash flows) reaching the 30-40% range. Excess cash builds very quickly, so capital
allocation is actually an underrated core competency of a successful executive in this sector.
There are also other favorable economics, such as getting to bank 12 to 24 months worth of
subscription revenues upfront while recognizing them one quarter at a time, reducing taxable
income while enjoying a 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. 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 an outdated GAAP (Generally Accepted Accounting Principles)
standard that have trouble interpreting the value of intellectual-property-oriented businesses.

Our core long term thesis thus comes into view: Such valuable companies are rarely for sale, so
it is very difficult to buy into them at a decent valuation. BlackBerrys turnaround is an
opportunity to get in at the ground floor, at a sensible price, of a proven leadership teams ability
to potentially build such a wonderful business.

So, with software sales on path to potentially tripling from fiscal 2015 to the end of fiscal 2018,
why has the stock remained essentially range-bound between $6-9 over the past 52 weeks?

5
https://medium.com/lightspeed-venture-partners/building-a-multi-billion-company-the-appdynamics-way-
f97dca401509#.dhyx546zd
6
BlackBerry, like many tech companies, use a different fiscal calendar. Fiscal Q1 2017 ended in May 2016, so fiscal
Q4 2017 will end in February 2017.

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When John Chen became CEO, he laid out a roadmap for the turnaround. 2014 was to be the
year of restructuring, stabilizing cash flows and right-sizing the firm, 2015 was to be the year of
pivoting hard towards the software business via acquisitions, and 2016 was to be the year we
begin to see growth overall. In 2016, however, the ghost of BlackBerrys past continued to haunt
them, because in late 2015, the company decided to launch a brand new handset, the
(unfortunately named) BlackBerry PRIV, the first to utilize Googles Android operating system
instead of a homegrown variant.

I was at first admittedly optimistic about the prospects of the handset, its terrible name aside. It
contained modern specs, had an 18MP camera, and sported a nifty slider mechanism that
revealed a physical keyboard should one be nostalgic for them or too fat-fingered to effectively
operate touchscreen keys. And it ran Android, so it had unvarnished access to the millions of
apps that people rely on. Furthermore, distribution agreements were struck with all four major
U.S. carriers for the first time in years, beginning with an exclusivity period on AT&T.
Unfortunately, all these bells and whistles added up to a price tag that was comparatively
astronomical $699 unlocked, which was around the range of both Apple and Samsung
flagships. There were also a small raft of software bugs that accompanied its premiere, which, at
$699, ended up being unforgiveable in as mature a product category as smartphones. The PRIV
ended up flopping just as bad as their previous efforts, and in late September last year, John
Chen announced the definitive shuttering of the hardware manufacturing business.

The flop of the PRIV will cost the company, I estimate, $300-400 million in all, factoring in
inventory write-downs, settlement of contract liabilities, and a final round of layoffs of
personnel dedicated to building devices. While it was not the multi-billion disaster that was
BB10, in hindsight, the PRIV was clearly a mistake7, one that set the company back a whole year
in its turnaround plan. I offer up some discussion and reflection in the below paragraphs.

(Figure 1: A flopped BlackBerry PRIV)

Given how much of BlackBerrys success this past decade was tied to handsets and given how
much its resources were tied to such, I believe Mr. Chen found it more difficult to disentangle
himself from that business than he anticipated. The most thorough explanation I suspect lies
upon two vectors. 1.) Not only was BlackBerrys assets strongly geared towards their prior
incarnation as a handset powerhouse, so was their culture, their self-belief, their identity. No
doubt there were a lot of talented designers and engineers and executives that believed in their

7
Well, the adoption of Android itself was not a mistake. Mobile software is now a duopoly between Apple iOS
apps and Google Android apps. Without apps, there is no raison d'tre for a smartphone. For BlackBerry to even
have a punchers chance, implementing Android was the only option as iOS has not and will unlikely ever be open
to any other OEM other than Apple.

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very marrow that they could succeed again if only they had another chance 8. And given John
Chen is not a private equity slash-and-burnerhe is a builderhis last tenure at Sybase, recall,
was over 12 years longhe perhaps thought it worthwhile to take one last stab at glory.

And 2.) a rapid shuttering of the handset division was impractical for intangible reasons, mainly
because BlackBerries are still the only plausible option in government, finance, healthcare, and
legal industries that work under strict security and privacy regulations, and the sudden folding
of what used to be BlackBerrys primary business would sever a direct channel to those
customers, a channel that would be critical to sell software through. Secondarily, BlackBerry still
receives a disproportionate amount of press attention, and a rapid shuttering would encourage
all manners of articles that speculated on the death of the company, a greatly exaggerated death
that would further shut the door of customers and potential customers, for who was likely to do
business with an entity that was believed to be dying? As such, a soft-landing so to speak was a
necessity, to have enough time to assure each and every one of their existing tens-of-thousands
of enterprise customers they were not going out of business and to change the media narrative
from death-watch to turnaround and pivot.

Overall, it was an instructive year learning just how difficult it is to overhaul a companys
culture/identity. But there are good reasons to believe the worst is past and we can look forward
to improved operating results because literally all of the losses last year were caused by the
handset manufacturing business, which is now definitively mothballed. No more Hail Marys
shall be hoisted from Waterloo, Ontario. In place is instead a handset licensing business.
Henceforth, BlackBerry will license their brand, their customized security-hardened version of
Android, and their intellectual property (IP) e.g. the physical keyboard to vetted third party
manufacturers 9 . Whether it will be a significant money maker is uncertain, but more
importantly, the potential of it becoming a significant money loser is effectively foreclosed as
there will be no physical or monetary capital behind the new BlackBerry smartphones. There is
no inventory risk, no expensive campaigns with questionable ROIs, no working capital
complexity with suppliers and distributors10. There is only a slice of royalty for every future
phone sold, and one cannot come up with a negative number by applying a % to an integer 0.

8
It is folly to fault such a mentality most companies seek to hire these type of never-say-die employees. Steven P.
Jobss legacy of Here's to the crazy ones, the misfits, the rebels... the ones who see things differently... while
some may see them as the crazy ones, we see genius, because the ones who are crazy enough to think that they
can change the world, are the ones who do is practically the DNA of the modern tech industry.
9
In Indonesia: Tiphone and various affiliates, who together make up the largest cellphone distribution network in
the country. India, Nepal, Bangladesh, and Sri Lanka: Optiemus Group. Rest of the world: TCL, a top 5
manufacturer in China and owner of the Alcatel brand.
10
You may be wondering whats the catch. The answer is, by giving up the risk, you also give up the reward to an
extent. If the (admittedly improbable) scenario where BlackBerry handsets make a dramatic comeback occurs,
their participation in the lollapalooza will be capped to their agreed percentage take wherever it sits on the P&L
waterfall while their manufacturing partner enjoys the upside of whatever operating leverage they get. Still, its
not a bad deal, and is truly economically win-win. Both BlackBerry and their partners want each other to succeed.
Only an organization with a good brand can pull it off, so consider this proof positive of the still-considerable
value in the BlackBerry brand.

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Looking forward, here is how the company stands fundamentally:

1.) A growing enterprise software business that will effectively offset all SAF declines going
forward.
2.) A nascent hardware licensing business that should wring out whatevers left of the
BlackBerry smartphone brand with almost no risk of loss.
3.) $1 billion in net cash (yes, that is billion with a b, and net, as in after subtracting debt).

BBRY closed 2016 at $6.89 per share, or a $3.7 billion market cap, of which I believe #1-3 above
account for more than 100% of such a valuation. That is assuming a pedestrian 3x EV-to-Sales
multiple typically reserved for sub-scale software companies with unclear growth prospects. I
have reasonable confidence that there can only be improvement going forward, mainly due to
QNX and its role in the burgeoning Internet-of-Things, which is worth spending a few more
paragraphs on.

QNX was the product a fellow University of Waterloo alumni in the early 80s, a so-called Real-
Time OS, an operating system designed to run on a very small footprint in very important, un-
fail-able projects (think nuclear reactors and such). QNX ended up under BlackBerrys umbrella
when BlackBerry bought them to build its BB10 mobile OS on top of the QNX OS11. In the
interim, 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 Harmans ownership, QNX
quietly went into the backbone of nearly all the automaker OEMs cars. You might be surprised
to learn that it is in 60 million automobiles on the road today with a market share percentage
north of 50%.

With such a headstart, it is likely QNX will extract their pound of flesh in the current automotive
technology revolution. There are two primary paths for QNXs revenues to increase. First, they
have made inroads in becoming a Tier-1 supplier (rather than as a Tier-2 under Harman and
splitting the cake with them, for example) with Ford being their first major OEM. That will boost
margins. Second, cars these days are practically computers with wheels, and what sets QNX
apart from their competitors, primarily open source Linux and Microsoft, is their proven
reliability in mission critical infrastructure12. QNX is expanding their CarOS into other parts of
the car such as over-the-air software updates, ADAS (Advanced Driver Assistance Systems) and
full-on autonomous driving, which will boost royalty per unit. Basically, they will make more per
sale and sell more per car.

When this will hit the bottom line is cloudier. Global auto sales are approaching 80 million per
annum. Assuming they can maintain their current market share of 50% and increase their per

11
Today, despite its app-starved condition, BB10 devices remain the single most unflappable, reliable smartphones
I have ever owned. They never crash. 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 if you like old-school keyboards, or the BlackBerry Leap if a full touchscreen is your
preference.
12
Rebooting a car whose digital dashboard has become a Blue Screen Of Death while going 65 mph on the
Interstate is emphatically not an option.

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car royalty to, say, $50 results in an annual run rate of $2 billion. Of course, this is an over-
simplistic piece of arithmetic; precise execution from sales down to engineering need to be done
to see this through, not to mention the increasingly intense competition for such a lucrative pie.
But enough pieces are in place with enough momentum to believe it will be a probable driver of
material revenue growth in the years to come.

To sum up a long (but necessary) section:

1.) The hidden value in BBRY is its worldwide enterprise software platform, which has been
turned around for growth by new management over the past couple of years.
2.) An expensive, all-in, Hail Mary launch of the BlackBerry PRIV flopped in 2016, which set
back the turnaround by a year.
3.) After the PRIV, BlackBerry will no longer design nor manufacture phones in-house, but
will instead license their brand and IP to third-party manufacturers with greater scale,
effectively removing all risk while retaining some upside.
4.) QNX is setting the stage for future growth beyond the existing enterprise software space.

General Motors

Our second largest position is General Motors (GM), a company I first initiated a position in
2014, shortly after their ignition-switch scandal broke. At the time, it was feared GM would have
to pay multiple billions in fines and civil liabilities, and worst of all, suffer a permanent
tarnishing of their brand. But it became progressively clear none of the above were going to
happen as time went by. Pushed on by the confluence of both low gas prices and pent-up
demand from the Great Recession, U.S. auto sales SAAR (Seasonally Adjusted Annual Rate) has
climbed steadily since 2009 with high-margin pickup trucks and SUVs leading the way:

(Figure 2: https://fred.stlouisfed.org/series/TOTALSA)

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By the start of 2016, GM effectively put their ignition-switch issues behind them, agreeing to a
$900 million fine with the Justice Department and paying out a further $595 million more to
affected consumers who elected to settle. Much credit goes to CEO Mary Barra who was handed
these unfortunate reins right when all hell broke loose and, instead of bobbing and weaving
from responsibility like too many of our corporate leaders today, stood in front of Congress and
took it 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 their Detroit peers. Case in
point: in late July Ford warned their 2016 numbers were going to miss expectations and in Q4
forecasted a gloomy 2017. After each subsequent announcement Fords stock sells off and drags
GM with it. Fords pessimism, however, was not reiterated by GM, which reported good quarter
after good quarter and gave an upbeat forecast for 2017. GM shares rally back raggedly but
persuasively the full year performance for Ford, down -21%, ended up a sharp contrast to
GMs 2.4% gain (excluding dividends).

Fundamentally GM experienced another fine year. Wall Street remains entranced by monthly
sales figures but less important is the absolute number of vehicles sold versus how much they
were sold for and how much it cost to achieve said sales. On the metrics that actually matter,
revenues grew 9% and adjusted per-share profits13 over 20%. It was not a surprise. Ms. Barra
and her management team forecasted this well in advance and simply executed they did what
they said they were going to do. They prioritized long-term profitability over the relatively
meaningless who sold the most cars award by de-emphasizing low-margin sales to rental car
companies (so-called fleet sales, reduced from 22% of total sales down to 19.6% of total sales)
and exiting or paring back exposure to struggling markets such as Russia, Brazil, and Thailand.

The stock, although fairly flat from December 31st 2015 to December 31st 2016, was a tale of two
halves. The first half saw a decline of -16.8%, mainly due to Q1 fears of a hard-landing in China
and then falling again on the back of the Brexit panic in late Q2. The second half reversed those
declines, gaining around 23%, primarily on the back of continuing good quarterly results. It is
pretty clear that, due to GMs size and the liquidity and its status as a consumer discretionary
cyclical 14 , the stock is a bell-weather security that is batted around by macro traders who
speculate on, alternatingly, the Chinese consumer, the American consumer, foreign exchange,
foreign policy, foreign catastrophe, you name it. And then occasionally investors realize its
trading at 3x EV/EBITDA and 6x earnings with a 4% dividend to boot. Thus goes the tug and
pull of various market forces oscillating between voting and weighing.

13
Adjustments include: ignition switch costs, Thailand and Russia asset impairments, and Venezuela currency
devaluations, substantially all of which were in 2015. 2016 has been remarkably clean, making the comparison
even more impressive.
14
That GM is a cyclical business is not in dispute. But as I wrote in last years letter, investors aversion towards
cyclicals is curious because such a reflex seems to be confusing the end-goals of investing which could not be
more basic: end up with more money than you begin with. Cyclical companies are trickier to value, but they
possess value nonetheless. Those applying blanket biases such as avoiding cyclical businesses or trying to time
the top regardless of valuation is akin to someone complaining that their dollar bill is not crisp enough. Value is
value, whether you get it in smooth or lumpy payments.

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This is an intermediate-term exploitable dynamic for us long-term investors. The survival of GM


over the next five years is not in doubt, with actual prosperity being a decent likelihood. There
are several ways to win here, one being the basic continuation of increasing EPS that should
raise the stock price even with a static multiple, and the other being the markets realization of
GMs growing differentiation with its Detroit peers and consequently deserving of an expanding
multiple that befits the industrys best-in-class operator Toyota Motors. Bagging both will give
us a highly satisfactory result over time. Understanding this has given me occasions to add to
our investment during opportunistic macro or peer-related freakouts.

There is one additional wrinkle to explain. Although I claim GM is our second largest position, it
will not appear that way when you look at your statement. You will instead see a ~2.5% position
in the GM common stock and a ~6% position in a GM WS B symbol. GM WS B is a warrant,
freely traded on the New York Stock Exchange, to purchase GM common for $18.33 per share
expiring on July 201915. Throughout the year I elected to increase our stake by began swapping
GM common for GM warrants. Because the common is trading well above that strike price, the
warrants act as de facto leverage16, allowing us to increase our exposure without spending more
cash. That 6% position roughly represents a synthetic 12% position in the common. The flip-side
is that the warrants do not pay cash dividends. It is my judgment that the liquidity we maintain
to buffer us in the event of further shocks against the cost of missing some quarterly dividends is
worth the trade-off.

Banking & Insurance

As mentioned in the opening of this letter, financials rallied hard in Q4, with the KBW Bank
Index gaining about 25%, specifically in the immediate aftermath of Donald J. Trumps victory
in the 2016 presidential elections. I wrote in my Q3 letter that:

I expect, however, there will probably be a fair degree of deregulation. With


Republicans in control of both the Legislative and Executive branches of government, it
appears likely they will, for example, peel back portions of the Dodd-Frank act that
regulated our banks. On the bright side, banks have been overcapitalized for a long
time now, forced to hold back on lending due to fears of another deep recession. This
could unleash more capital and perhaps put the onus of growing our economy on fiscal
policy rather than the more ineffectual monetary policy. On the other hand, we all
remember the dark side of making reckless loans

The theory still holds true here in early 2017 although no actual legislation or regulation has
been formally repealed as of this writing. In any case, our investments in various financials have
never been a wager on the direction macroeconomic policy.

15
The warrant was issued as part of their restructuring in 2009.
16
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, $35 to $36, the warrant theoretically goes
from $16.67 to $17.67. We are exposed to the equivalent $1 move but we only need to spend $16.67 per share
rather than $35 per share.

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Customers Bancorp (CUBI) was a star performer for the second straight year, gaining
around 30% in 2016 after gaining roughly 40% in 2015. Its closing price of $35.82 at year-end
2016 is a clean double from our initial position established around $17 in Q4 of 2013.

Customers is the second act of CEO Jay Sidhu, the former boss of Sovereign Bancorp who grew
it from a tiny thrift into a $89 billion asset powerhouse. He suffered an ignominious exit,
however, as he lost a battle against a disgruntled activist in 2006. A non-compete clause kept Mr.
Sidhu on the sidelines until 2009, when he led a recapitalization of New Century Bank, took
over as CEO, tacked on a couple of acquisitions, and rechristened the resultant entity as
Customers Bancorp. Over the years, Ive come to appreciate the proverbial chip on the shoulder
trait in management teams. Jay Sidhu was pushed out of Sovereign, a bank he spent the
majority of his career building. If anyone has an incentive to reclaim a legacy, its him. He set up
shop in the same city where he built his previous empire and rallied his old Sovereign executive
team back together. By 2013, four years after taking control of the erstwhile New Century Bank,
Customers Bancorp had grown assets from $350 million to $4 billion.

Customers is primarily a business bank that eschews the land-and-expand-branches method of


growth and instead focuses on recruiting 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 (see graphs below). 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 0.22% of assets compared to peer/industry averages of around 1%).

(Figure 3: Source: Per company presentation: SNL Financial, Company data based on continuing operations. Peer data
consists of Northeast and Mid-Atlantic banks and thrifts with comparable size in assets and loan)

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However, it is my estimation that the stocks considerable gains over the past two years is
unlikely to be replicated in 2017. CUBI in 2013 was a relative unknown in the industry beyond
Mr. Sidhus (in)fame(y)an idea I stumbled upon whilst combing through the an issue of
American Banker profiling the CEOtrading at roughly tangible book value (TBV). Since then,
in conjunction with a steadily growing EPS ($1.30 per share in 2013 to $2.30 per share in 2016),
its P/TBV multiple has also expanded from 1.0x to 1.7x, creating a double-tailwind for its stock
price. Growth in the former is predictable and likely, but growth in the latter is less so. Given
that a 1.7x P/TBV valuation is now in-line with its peers, we should be appropriately satisfied
with any further gains that match its EPS growth in stride.

A wildcard exists in its BankMobile subsidiary, a digital bank that was launched in 2014 with a
mobile-only interface aimed at serving millennials and post-millennials. This is Mr. Sidhus
attempt at cracking the red-hot FinTech space, of which involve companies that are awarded
valuations far greater than those in traditional banking. This venture-style endeavor is probably
coming to an end in 2017 in the form of a divestiture, which the company has admitted to being
due to regulations that would limit earning interchange fees if they held BankMobile while
surpassing $10 billion in total assets. BankMobile accounted for $79 million on the balance
sheet as of Q4, but if somehow Customers is able to finagle a sale price akin to what some
FinTech companies are commanding in Silicon Valley, there could be a windfall that possibly
adds $1-2 per share to CUBIs tangible book17. Allow me to stress that I am not expecting this,
and that this merely free upside should fortune smile upon us.

***

In early Q2 we fully exited Atlantic Coast Financial (ACFC), realizing a ~50% gain in just
over a year. This is the second bank we have profited from the involvement of Jay Sidhu, a
member of the board of directors, who fought off a takeover attempt by Bond Street Holdings in
2013 and instead urged the bank to recapitalize via a public offering and rebuild by basic
blocking and tackling in a lucrative Florida region. We invested at around $4 per share in mid-
2015 and exited around $6.

ACFC vs. CUBI is a good example of a Special Situations investment versus a Compounder
investment even though both are in the banking space. ACFC was purchased at around 0.8x
P/TBV and sold around 1.1x while CUBI was purchased around 1.0x P/TBV and remain in our
portfolio at 1.7x. The main difference is that Atlantic Coast is a significantly smaller bank than
Customers and is thus sub-scale. It is extremely difficult for small banks to earn a decent ROE
(Atlantic Coasts was 7.5% in 2016 and I consider it basically maxed out at their current asset
level) with todays compressed interest rate environment, capital requirements, and regulatory
expenses. ACFC will still compound, but not at as high a rate as CUBI. We instead invested to
capture the closing of the valuation gap that a distressed, recapitalized company makes when it
transitions into a healthy going-concern.

17
It should be noted that Mr. Sidhu recently entered into an agreement with the Board whereby he is entitled to a
cash bonus of 10% of the sale price if BankMobile exceeds $100 million:
https://www.sec.gov/Archives/edgar/data/1488813/000095015916000833/ex10-3.htm

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As an aside, while P/TBV is a popular method to value financials, larger, more mature
companies deserve to be valued on earnings. Book value based valuation is a what theyre worth
if theyre dead method, while earnings based valuation is what theyre worth if theyre alive.
So while CUBI looks comparatively expensive to ACFC at 1.7x P/TBV, its 12x forward P/E is
much more reasonable. ACFCs 1.1x P/TBV translates to a 14x forward P/E, so as a going-
concern, ACFC in my judgment is actually pricier than CUBI today.

***

CIT Group (CIT) is a middle market lender undergoing a multi-year transformation ever since
emerging from Chapter 11 bankruptcy caused by the financial crisis. It has been a rough road, as
their previous incarnation relied heavily on high-cost funding obtained in the capital markets
and serviced capital-intensive industries such as railcar and airplane leasing. Most of the effort
involved finding ways to cut down their cost of capital and deploy it more efficiently.

In late 2015, CIT closed on the purchase of OneWest bank, itself a resurrected phoenix from the
ashes of infamous subprime mortgage lender IndyMac. This pice de rsistance is supposed to
drastically decrease their cost of capital by providing an FDIC-insured banks low-cost deposits
as their primary funding base. Then about a year later in 2016, CIT struck an agreement with
Avolon Holdings to sell them their entire aircraft leasing business for $10 billion, an
approximately 6.7% premium to its book value. These two strokes leave CIT today a much
different beast than the one in 2009 that stumbled into bankruptcy with its inefficient business
model.

But as mentioned, it has not been easy, particularly with regards to the OneWest purchase,
which, with its ties to Trumps Treasury Secretary to-be Steve Mnuchin, has vaulted CIT into the
limelight as a political football. OneWest has proven to bring as much headache as benefits thus
far, first incurring a $230 million charge related to their now-defunct reverse-mortgage business
in Q2 and then another $327 million of Goodwill impairment in Q4.

Nevertheless, CIT is grinding through their issue, and the most recent losses were all non-cash
charges that impaired neither their core earnings power nor their capital ratios. I am expecting
2017 to be a cleaner year. CEO Ellen Alemany, former CEO of Citizens Financial, came out of
retirement last year to take the reins from John Thain. Mr. Thain, to his credit, is a bold decision
maker; the OneWest acquisition was his brainchild and despite its problems, the strategy of
acquiring a large deposit base to lower funding costs is a sound one. While Mr. Thain has more
of a dealmakers mentality, Ms. Alemany, according to several reports, has the detail-oriented
construct of an operator.

The sale of the banks air leasing business is the final big piece of the reconstruction. $10 billion
of assets will be converted to cash after the deal closes, with $3.3 billion being earmarked for
return to shareholders (a very significant 35% of their market cap), which will come as a mixture
of buybacks and special dividends. By 2018, CIT should look very much like a vanilla
commercial bank, one that is right-sized, with an enviable roster of middle-market clients and a
century-old heritage.

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CIT currently trades at a discount to tangible book value: 0.9x, yet CIT also has the size and
scale to achieve 10%+ ROEs. This makes CIT a unique investment, one that could transition
from a Special Situations to a Compounder. This is predicated on Ellen Alemany and her teams
execution, of course, of which is far from a guaranteed thing.

***

Shifting from banking to insurance, Atlas Financial (AFH) remains a top three position in
our portfolio for its attractive compounding characteristics. Atlas specializes in taxi, limo, and
paratransit insurance, a niche corner in the commercial auto insurance space, and is led by CEO
Scott Wollney, who is also its de facto founder. Atlas was formed from the remains of the
crumbled empire of Kingsway Financial, a hodge-podge collection of insurance businesses that
stagnated from neglect. Mr. Wollney, then a Kingsway executive, led a management team that
cherry-picked Atlass current subsidiaries out for a rebuild, betting their niche business was a
diamond in the rough. The bet was a good one. From 2011 to 2016, their core commercial auto
premiums have grown from $20 million to over $200 million18.

AFH shares declined -9.3% for the year due to fears of their slowing premium growth which,
after several torrid double-digit growth years, will probably level off for the foreseeable future.
The elephant in the room is Uber and Lyft, or in industry parlance, Transportation Networking
Companies (TNC). The rapid rise of TNCs have pressured the traditional taxi business and
forced out many marginal operators who relied on medallion monopolies for their profits. Less
taxis on the road mean less of their insurance premiums are up for grabs.

This is an issue more complex than meets the eye. To the consumer, TNCs have generally been a
wonderful thing. Getting rides in cities have never been easier. However, there is a reason
beyond monopolistic greed why taxis cost more they are heavily regulated to ensure safety of
both drivers and passengers. And one big cost is commercial insurance. Giving a ride and getting
paid for it is a commercial endeavor and there are liabilities if the driver gets into an accident
that are not covered by a personal auto insurance. Regulation has not yet caught up with reality,
as different jurisdictions are variously influenced by different taxi unions and insurance
providers are experimenting by offering part-time ridesharing policies19. Atlass business will
likely stall for a period while this shakes out. While they do offer commercial policies for TNC
drivers, its not for those who drive part-time, only for those that are part of a larger fleet,
purchased by the company for their drivers.

We maintain our sizeable position for the simple fact that we got in at a fair price and the
business is generating acceptable returns even without growth. For the last twelve months Atlas
has written $222 million in premiums with an excellent combined ratio of 87%, resulting in a
pre-tax income of $29 million. Our cost basis in AFH is around $16, implying an ownership

18
We sadly missed out on AFH during its Special Situations phase as it spun out of Kingsway, even though I was
nominally aware of it back in 2013 when shares were trading in the mid-single digits. Chalk this up as a mistake
by omission.
19
A good overview for some bedtime reading should you so choose: http://www.insurance.com/auto-
insurance/coverage/insurance-rideshare-uber-lyft.html

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created at a valuation of ~$190 million. Therefore, we essentially bought the company for < 7x
pre-tax earnings (as a sanity check, their book value has grown at a roughly 15% clip over the
past two years, i.e. a 6.67x multiple). That is a good solid price to own a stable compounder at.

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 owners mentality. This
means, in the face of slowing premium growth, as all insurance companies are wont to
experience sooner or later, to focus on underwriting results and not on chasing premium dollars
of lesser quality. As stated above, simply staying the course should result in satisfactory returns
even without any significant top-line expansion. As premiums are earned in, there are many
levers with which to pull to maintain their ROE, such as reducing the amount ceded to
reinsurers or returning capital to shareholders. Mr. Wollney has been blunt in conference calls
that detail just such a strategy, constantly emphasizing underwriting being the core mission,
giving me the confidence he is unlikely to go rogue.

***

Finishing off our banking and insurance section are United Insurance Holdings (UIHC)
and Heritage Insurance Holdings (HRTG), two players in the southeast U.S. property
catastrophe insurance space. Of the two, United has had a longer history with us, first joining
our portfolio back in Q3 of 2013 at an initial cost basis of $7.32 per share. Its been a bumpy but
ultimately profitable ride, with several instances of trimming and rebuilding the position as
shares rose above $28 in early 2015 but skidded back into the teens over time. I elected to divest
of all shares in November last year.

Our investment was initially predicated on a Florida property catastrophe insurance market that
was undergoing a transformation from being dominated by state-owned entity Citizens Property
Insurance to being depopulated into the hands of multiple private insurers, of which United was
one. The appeal was a simple one: when you are the beneficiary of a depop, you incur much,
much less acquisition cost per policy than the traditional process of hiring agents and brokers
and paying them commissions. Such unusual economics briefly delivered combined ratios in the
60s and 70s, resulting in enormous ROEs that more befitted those in Silicon Valley.

That veritable cash grab was, of course, transitory. Afterwards, it becomes necessary to build out
a real insurance business if one wants to remain a going concern. United has done a laudable job
expanding their book of business to other states along the Atlantic coastline, which was the
reason why we continued to hold the stock. Policies in-force outside of FL have reached 50/50
equilibrium with Florida policies. But their efforts at diversification have had mixed results on
the underwriting side. Unusual winter storms in the northeast, abnormal hail in Texas,
atypical water-related claims in the Florida tri-county area began popping up regularly.
Their thus far inconsistent underwriting in non-catastrophe losses made it a double-whammy
when the first hurricane to make landfall in Florida in 11 years, Hurricane Matthew, raked up
the state and will likely force United to incur their full $30 million catastrophe reinsurance
deductible. In the history of insurance failures, subpar underwriting has been the dominant
cause to blame. I sense the company edging into the risk of extra-rapid expansion without the

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accompanying infrastructure and expertise in place. For that reason, Ive decided its best to take
our profits for now and watch from the sidelines.

Heritage Insurance has a similar genesis as United, but it is my observation that CEO Bruce
Lucas and his team are more careful underwriters. I have followed HRTG since its IPO in 2014
and watched its stock inflate into silly levels of valuation. Only when it almost completely
deflated last year did I initiate our investment. Although Heritage is embarking on a similar path
of diversification outside of Florida as United did, their progress has been deliberate and slow 20.
Their loss ratios have consistently been lower than Uniteds and they communicated to investors
with greater alacrity and frequency in response to Hurricane Matthew. Heritages ultimate
claims will also likely be lower than Uniteds despite having a greater concentration of their
policies in the swath that was devastated. So for now, we remain invested in HRTG but are
keeping a sharp eye on it.

A Quick Tour Of A Few Others

Billy, the Canadian alternative energy power producer I talked about in the 2014
investor letter21, remains a staple in our fund as it has been for over four years now (five
if you consider my private investments prior to Incandescent Capitals founding).
Nothing has changed with the core thesis. Wind keeps blowing and water keeps running
and their cash keeps flowing, driving their stock up another 32% in 2016, making it the
largest contributor of our gains. It has been the ideal compounder and is Exhibit A as to
why compounding works:

(Figure 4: A four year chart of "Billy", a boring but steady compounding machine)

20
An interesting tidbit: Uniteds previous chief underwriting officer Melvin Russell left for Heritage in late 2013.
21
Which, unfortunately, I will continue to demure from revealing for now due to political reasons. Call me if you
want to know.

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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 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
wouldnt be able to 22 . Ricardo is a Special Situations investment because they
recapitalized in 2014, taking out a $25 million term loan to repurchase 50% of their
shares outstanding at the time. The main purpose was consolidating control under a
private equity fund, the vehicle of a respected activist with a long and sterling track
record of value creation. The key attraction: the fund is entirely self-financed, therefore it
has no pressure from outside investors to monetize. To put it plainly, our sponsor gets to
be a long-term investor with no potentially irrational motivations. We like putting our
money with folks like that. Ricardo has, since the recap, simplified their business and
redirected all excess cash flows to debt reduction, even electing to delist from an
expensive stock exchange. The aforementioned $25 million term loan has shrunk to $9
million in just a little over a year, a frankly astonishing pace one rarely sees. It is possible
that once debt is completely eliminated, potentially by mid-2018, Ricardo simply takes
out another term loan and buy out the rest of the equity (including ours) outstanding.

Calpine (CPN), an independent power producer that owns a fleet of best-in-class


natural gas power plants and a cache of geothermal assets called the California Geysers,
has had a rough couple of years. However, our fundamental thesis remains unaffected:
Natural gas is Americas primary power source now that king coal has been usurped by
concerns of climate change. Calpine owns arguably some of the most efficient natural gas
fleets in the industry along with the Geysers which provide essentially unlimited free fuel
in the form of geothermal steam. The entire IPP space has in essence been left for dead
by the Mr. Market due to the fear of endless renewable energy and a glut of new power
plants coming online that may depress power prices for a long time. This has resulted in
very wide spreads between the cost of a new-build and the cost of owning the equity of a
holding company with stakes in existing high quality natural gas powered generators like
Calpine on a dollar-per-kilowatt basis. This is, in my estimation, a short-to-medium term
mispricing phenomenon that will reverse over time.

Dish Network (DISH) spent most of 2016 quietly (stock effectively flat, gaining +1.6%)
due to the FCC broadcast spectrum incentive auction that began in late Q1 and is only
now wrapping up. This is an auction that will take airwaves previously belonging to
traditional TV broadcasters and repurposing them for wireless broadband use. Since
Dish is a participant in said auction, as are most major wireless carriers and several
major cable providers, a mandated quiet period is in force, so there has been no chatter
regarding what Dish plans to do with their hoard of wireless spectrum that approaches
T-Mobiles in size. As I wrote in last years letter, owning the Dishs spectrum is like

22
I began my post-undergraduate career in just such a company so I am quite familiar with how the sausage is
made.

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owning virgin beachfront property in an area that is all but certain to be densely
populated soon. The prices weve paid for Dish shares is, I believe, a fair value for their
satellite TV business (including Sling TV, their so-called over-the-top service that
delivers live TV over the internet23) with all that spectrum included for free. While Mr.
Market may not be patient enough to see how CEO Charlie Ergen, who founded Dish
when it was just two satellite dishes and a truck, monetizes its spectrum, we certainly are.

Daphne is a Canadian microcap, also too small and illiquid to be revealed throughout
the extent of our involvement, which joined our portfolio in late Q2 as another Special
Situations name that underwent a restructuring that involved, first, a massive secondary
sale of nearly a billion shares (over 97% dilutive) used to repay some $30 million of debt,
then another private placement of 200 million shares for good measure, and finally a
100:1 reverse split to soak all that penny stock back up. Whats left is a shareholder base
of mostly insiders and board members and a motley crew of individual speculators. Just
our kind of hairy playpen. Daphne is a B2B provider, offering Canadian businesses
document and marketing print services. This is not a growth business, frankly, but there
is ample proof that it is possible to produce shareholder return in a no-growth arena,
especially when our purchase price was 4x normalized free cash flow. One simply has to
look back at my 2014 annual letter about another Canadian company, Supremex (its real
name, ticker on TSX: SXP), which peddles in no-growth envelope manufacturing, which
we purchased for $1.80 per share, also at 4x FCF, and eventually sold for $3.04 24. To be
clear, I am not predicting a similar return here. Daphne took a dive in November due
to a greater-than-expected tie-up of its working capital, forcing the company to dip into
its bank overdraft. This is not a trivial issue. The jury is still out on the ultimate
survivability of this company, which is why we will keep this position small for now, one
that may cause some pain, but may also return two or three times our money if they turn
the corner and stabilize operations.

Mistakes of Omission

Strange as it may seem in a year where we trailed the S&P 500, there were no glaring mistakes I
typically enjoy flagellating myself with here in this section. From a mark-to-market perspective,
BBRY caused the largest drag by far, but as painstakingly detailed in the deep-dive, there are
good reasons to believe in the probable long-term success of John Chens vision and execution.
We are buckled in for an extended haul and have no regrets thus far. Our next largest drag,
Daphne, was less than half of BBRYs and is still in the early innings of the thesis and besides,
has the attributes of a coin toss where its heads we win 2-3x and tails we lose 1x or less. Only
three other names declined during 2016: AFH (-0.87% drag), also a here-for-the-long-haul

23
This is not just a gimmick. Sling is now, according to research firm Parks Associates, the #6 OTT provider in the
U.S. behind Netflix, Amazon, Hulu, MLB.TV, and WWE, but ahead of HBO Now, Showtime, and CBS All-Access
(https://www.parksassociates.com/blog/article/pr-10262016). No mean feat and certainly valuable, contrary to
the assertions of certain short-sellers.
24
Cue the regret ditty: SXP closed at $5 per share at 2016 year-end.

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name; UIHC (-0.82% drag), one we already booked significant gains in 2014; and CPN (-0.50%
drag), a mid-inning prospect a la Daphne but with far less downside.

Instead, my biggest regret of the year lies in not being more aggressive in general. They are
mistakes of omission, or what Warren Buffett colloquially call: thumb sucking. By the end of
January alone there were opportunities to back the truck up on nearly all of our favorites, as well
as in late June post the Brexit panic25. Berkshire Hathaway (BRK), for instance, was trading
very nearly at 1.2x book value, a level that Buffett has explicitly stated he will begin to use its
colossal $70 billion war chest to buyback stock. I could have made it a very large position with
the comforting knowledge that he was ready and willing to defend a specific stock price ad
infinitum.

Furthermore there were a handful of names that I was very familiar with but for some reason or
another did not pull the trigger during windows of opportunities. One example would be
Advanced Emissions Solutions (ADES), a stock which we traded successfully in 2013 but
subsequently ran into some pretty severe accounting problems over the next two years. I never
stopped watching them though, and by Q2 of last year they appear to have emerged, badly
deflated, but with their core operations and contractual cash flows intact. I knew the stock was
all but shunted to the hinterlands with almost no institutional investors awareness around it
and I could pretty clearly calculate their valuation (cheap) given the information they provided.
But for some reason, I did not even buy one share.

Or take VMware (VMW), which became mispriced after a sell-off in Q4 of 2015 when its
future was mired in uncertainty over Dells $67 billion takeover of EMC (EMC owns 80% of
VMware; the remaining 20% is floated publicly). During that time there was a torrent of
speculation surrounding its future and what kind of financial engineering shenanigans Dell
would need to concoct to swallow EMC & their majority stake in VMW whole. Sales performance
inevitably suffered under such distractions. VMware, however, is undoubtedly the crown jewel
of the bunch. The company has developed a suite of software over the years that power critical
IT infrastructure. I knew this. But even as the stock declined from the $80s down to the $40s, I
did nothing. I told myself to stay patient, to wait for an even bigger discount, but instead I
watched as that murk slowly cleared and VMW climbed right back into the $80s.

In both cases, thumb remained ensconced firmly in mouth as the share prices slowly picked up
steam and left the value station. When the robins came, spring was over.

***

I wish I could promise such mistakes of omissions will be eliminated from now on, but the fact
of the matter is a certain level of conservatism is baked deeply into your portfolio managers
persona. This defect I mitigate by having a long-term view, one that spans multiple years, and
associating with likewise long-term partners like yourself, which ultimately permit me
aggression when warranted without fear of sudden redemption. It is the hedge fund equivalent

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For the record, I did add, but daintilyonly those investors (including myself) who added to their capital at my
behest did slightly better.

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of matching asset/liability durations. On this note, give yourself a hand throughout 2016s
periods of volatility, there were no anxious e-mails or calls, just thoughtful feedback and parlay.
Indeed, all throughout the year, Ive been the beneficiary of nothing but quiet confidence from
each and every one of you. This, above all else, gives me great optimism in the likelihood of our
future prosperity together.

A Look Ahead

So far, 2017 has gotten off to a more buoyant start than 2016 did. Debate rages across the
internets as to whether the markets continued optimism is the last, long tooth of the U.S. bull
market going into its ninth year, or if its the dawn of a new, pro-growth era driven by pro-
growth Republican who control both House and Senate as well as the White House. My opinion,
as you might guess, is agnostic26. Because in each of our main equity positions we have in place
management whom I staunchly believe are qualified and rational. That means we have the
luxury of placing our trust in them to bob and weave against whatever obstacles they face. My
part of the job was in selecting them and their businesses.

We still remain a little cash heavy for now. Cash is, afterall, not just a hedge, but a call option on
future unforeseen opportunities. We are prepared should there be storms. With that said, it
would not surprise me if Mr. Market grinds out another positive year. The world economy
remains stuck in a growth starved rut. Without growth there is limited likelihood in interest
rates rising dramatically. And without interest rates rising dramatically there are very few
options to find returns outside of the equity market. Stocks can rise by default as cash is sloshed
through the system. But the beauty of value investing is getting to keep your cake and eat it too,
as long as you have some patience and fortitude. Should stocks fall, we are happy because we get
buying opportunities. Should stocks rise, we are happy because we make money. No wonder we
tap dance to work.

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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Not because I dont care. Quite the contrary, I am nearly mesmerized by the volume of news and tumult that hit
the wires daily. The United States, and by extension, the rest of the world, will almost certainly look different in
the next few years. But it is too early to know how.

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