It has been said that man is a rational animal. All my life I have been searching for evidence which could support this.
2016 was an extraordinary year. Events in the United States and abroad have caused everyone to take a step back and reconsider conventional wisdom. I read an interview a few days ago that encapsulates the feeling well. A favorite band of mine, U2, had completed a new album that they had planned to release at the end of 2016. U2’s guitarist, The Edge (which would be a great nickname for an investment manager, by the way), explained why they delayed the release, “We just went, hold on a second – we’ve got to give ourselves a moment to think about this record and about how it relates to what’s going on in the world.”
Investors need to do the same. The effects of uncertainty are now considerably higher. One Donald Trump tweet can cause a company’s stock price to drop dramatically. One off-handed comment from a government official can negatively affect an entire industry. Of course public policies have always affected companies and industries. The difference now is how quickly it can happen and how quickly share prices react and sentiment can change.
At the same time, not all uncertainty is bad. We don’t yet know exactly what the final results will be, but it appears that Dodd-Frank will be changed in a significant way. It also appears that corporate tax rates will be meaningfully reduced, as well as personal capital gains taxes. These are all positives for the markets and for our holdings.
The other part of this is that the Arquitos portfolio benefits from more volatility. We are arbitraging perception from reality, and markets tend to overreact. If the share price of a company I like is negatively affected by impulsive decisions of other investors, it creates an opportunity for us. The challenge, as always, is to try to stay as rational and analytical as possible.
We experienced the Trump effect in a major way with our Bank of America position. We have owned Bank of America Tarp Warrants since the inception of the fund nearly five years ago. Our average purchase price is $4.96. I have long believed these warrants are worth several multiples of what we paid for them, with or without significant policy changes. We have continued to hold them despite the price not moving in a material way for years at a time. On election day these warrants traded for right about $5. We had been running to stand still for more than four and a half years. Then, everything changed. They ended the year at $9.95 and are even higher today.
Those warrants helped our 2016 performance, but they were far from the primary driver of our outsized gains. That prize belongs to Intrawest Resorts Holdings (SNOW). I have written about Intrawest in previous letters. The general thesis was that the company was more effectively allocating capital than in the past and that the largest shareholder was incentived to maximize the company’s value in a short amount of time. Fortress, a large private equity firm, owns 60% of Intrawest within a Fortress fund that is maturing this month. They brought Intrawest public in 2014 to lackluster interest. In 2014 Fortress brought on a new CEO who had a mandate to improve returns on invested capital. He has succeeded.
In January 2016, Intrawest sold their time share business and did a tender offer for about 12% of the outstanding shares. Fortress did not sell shares in the tender offer. Because of that, I ramped up our ownership of the company from a small starter position to our largest holding. Shares rose 118% in 2016. We captured all of those gains.
The story doesn’t end there. The likely end game was always that Intrawest would sell itself. This is the best way for Fortress to maximize the value of its shares and exit the investment. An outright sale would benefit us as passive shareholders as well. There have been indicators that this was coming. The company’s reporting has improved over the last year and management has started to provide more clarity on guidance.
Last Friday, January 13th, the sale thesis was confirmed. Reuters reported that Intrawest is working with investment banks, and that Fortress had reached out to several other private equity firms. Because of that news, shares have risen to above $20. They had ended 2016 at $17.85. Our average purchase price is $7.50.
A deal could be structured in a wide variety of ways. There could be an outright sale to a competitor. A consortium of ski operators could be involved, as could a strategic buyer or another private equity firm. The company could be split up in order to facilitate the sale of specific properties. Fortress may find a buyer for its shares or they could offer them to the public.
There appears to be an appetite for deals out there as Vail Resorts completed its acquisition of Whistler in October 2016 at a rich valuation. A unit of Och-Ziff even got involved recently, acquiring 14 ski resorts, though for the value of the land and not as operators.
Intrawest is not a well-followed company, but Macquarie upgraded the stock yesterday and gave it a $25 price target. It remains to be seen what price Fortress can get for the company, but it will undoubtedly be more than the current share price, perhaps significantly so.
Since the fund’s launch on April 10, 2012, we have beat the S&P 500 four out of five calendar years and have beaten that index’s annualized return by 15.3% per year. In three of those years we returned more than 46% net of fees.
Now is a good time to reset expectations. In my first investor letter I told the story of Marty McFly from “Back to the Future.” If he would have invested $100,000 in the S&P 500 in 1955 and left it there for 30 years he would have ended up with $1.5 million in 1985. During that time the index returned 9.5% per year. If he found an investment manager who could beat the index by 2% per year, that $100,000 would have been worth $2.6 million, not $1.5 million. If he found an even better investment manager, someone who was able to beat the market by 5% per year over 30 years, then that $100,000 would have turned into $5.8 million.
We don’t need to continue to beat the market by 15% a year to achieve success. With your patience and commitment, we can compound assets in an astronomical way if we are able to only slightly beat the overall markets over time. I will certainly continue to look for companies with low risk and high return potential, and I am certain we will continue to do well over time. However, it is highly unlikely this extreme level of outperformance can continue.
The above post has been excerpted from a letter of Arquitos Capital Management.
Disclaimer: This letter is for informational purposes only and does not reflect all of the positions bought, sold, or held by Arquitos Capital Partners. Any performance data is historical in nature and is not an indication of future results. All investments involve risk, including the loss of principal. Arquitos Capital Partners disclaims any duty to provide updates or changes to the information contained in this letter. Performance returns for Arquitos Capital Partners reflect the fund’s total return, net of fees and expenses. They are net of the high water mark and the 20% performance fee, applied after a 4% hurdle, as detailed in the confidential private offering memorandum. Performance returns for 2016 are estimated by our third party administrator, pending the year-end audit. Actual returns may differ from the returns presented. Positions reflected in this letter do not represent all the positions held, purchased or sold. This letter in no way constitutes an offer or solicitation to buy an interest in Arquitos Capital Partners or any of Arquitos Capital Management’s other funds or affiliates. Such an offer may only be made pursuant to the delivery of an approved confidential private offering memorandum to an investor from Arquitos Capital Partners.