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Interview: Investor Steve Kiel's Answers to GuruFocus Reader Questions

- By Holly LaFon

Last month, GuruFocus took readers' questions about investing for Steve Kiel, an outperforming portfolio manager and founder of Arquitos Capital Management. Kiel's firm, based in New York, focuses on 12 to 18 holdings of primarily North American companies within its concentrated portfolios. Because of his emphasis on conviction, the top five holdings often account for up to 75% of the fund.


Since starting New York-based Arquitos in 2012, Steve has achieved returned of 21.3% annually after fees, beating the market's return by almost 10% per year. Before launching his hedge fund, he had a career as an attorney and served in the Army Reserves. Read more about Kiel here, or see him speak at the 2019 GuruFocus Value Investing Conference.

Below are the answers to GuruFocus readers' questions from Kiel:

Question: Do you feel the same way about MMA Capital Management (MMAC) now that the price has gone up so much recently?

Kiel: MMAC has been a great investment for five years-plus. It has been a joy to be a passive owner and watch CEO Mike Falcone and his team execute so well. Arquitos owns just under 5% of the company and it is our largest position.

The investment is more attractive now than at any time since we've owned it even though shares are near all-time highs. How can that be? They have dramatically simplified the business, entered a strategic partnership that allowed them to monetize their off-balance sheet assets, and re-allocated their capital into higher-growth investments. Even with this operational success and the run-up in price, shares still trade at less than 90% of book value.

MMAC will likely be added to the Russell Micro-cap Index over the next few months, which would be a boon to the stock. Even if it isn't added this year, the stock should trade above book value, and book value continues to grow.

Question: What about NOLs? Why do you like those kinds of companies?

Kiel: The NOL companies were a moment-in-time investment. For those not familiar with the term, NOLs are "net operating loss" carryforwards. They arise from prior losses that are allowed to be offset against future gains. Sam Zell is the king of monetizing these companies going back to the early 1980s when the tax law first changed to extend the number of years in which they could be used.

So-called NOL shells were a thing several years ago. Arquitos did very well with a company named ALJ Regional Holdings, for example.

The situation is much different today. The corporate tax law change diminishes the value of the NOLs since the corporate tax rate is lower. Additionally, most of these companies have been picked over. I actually am now more interested in companies that could be considered to be the opposite of NOL companies. The value now appears to be in companies that are or have converted to C corps in order to pay the new corporate tax rate. KKR & Co. Inc. (KKR) is the best example here. It converted from a public partnership to a C Corp last year. It is still cheap but the new legal structure allows it to be owned by a wider number of investors such as certain mutual funds and index funds that are not able or willing to own public partnerships that issue K-1 statements.

You have to be adaptable to whatever situation you find yourself in. The goal is to find mispricings. In 2013 the mispricing occurred because the NOLs were underappreciated. Today's mispricings are different.

Question: In the early days of the Buffett Partnership, he was known to scour the pages of a Moody's Manual or S&P Stock Guide to source ideas. What methods do you use today to procure investment ideas?

Kiel: When I first started investing I would simply go through each company on the Pink Sheets starting with the letter A. Most of those companies were tiny and easy to analyze. I'd recommend doing that for new investors. It is a great way to learn and you might uncover a big opportunity that you could take advantage of with a small investment.

Arquitos is too big for those types of companies now so I have tried to refine the process. I'll take a quick look at every S-1 filing and generally look through various other Securities and Exchange Commission filings each day. I also have a lot of alerts set up for various keywords, terms and names. I'll share one secret. I have a Google Alert set up for the term "contingent value right." With that, you'll come across each instance when a CVR is included in a merger or divestment. The opportunity to invest in a company issuing one is very rare, but it has the possibility of being a tremendous opportunity, so they are interesting to follow.

Charlie Munger (Trades, Portfolio) has a story about how he read Barron's for 50 years and only acted on one idea from it. However, that idea earned him $500 million dollars, so all that time going through Barron's was worth it. That's how I feel about some of the alerts and filings that I look through each day. There is still a lot of turning over rocks, but they help to focus on situations where opportunities are most likely to exist.

Question: Sitestar has an Investment Management division where one of the funds is a Select Fund. This Willow Oak Select Fund takes the best ideas from investment managers and puts those picks into one fund. My question is this: During the most recent Daily Journal meeting, Charlie Munger mentioned an exact situation where an investment shop took the best ideas from talented and smart money managers and they failed miserably. They tried it again and failed once more. What makes you think that the Select Fund will have a different outcome?

Kiel: It's an excellent question. The answer is that Select is doing something different than what Munger was referring to. Munger's reference was to a fund that took the best ideas from their internal people. In hindsight, you can see why this would be a problem. By spending so much time on an idea and presenting it as one of their best ideas, the analyst is now put in a position where it will be very difficult for them to change their mind. There is a sunk cost with the time put in, and it is very difficult for someone in that situation to change their mind or admit they had made a mistake.

What Select does is solicit ideas from external managers. Select's portfolio manager, Rodney Lake, and its adviser, Mike Bridge, then independently research the company and determine whether it fits their criteria. Rodney and Mike will reject an idea, even a good one, if it doesn't fit their investing framework and circle of competence. They then independently monitor the holding and independently determine its allocation size and when to buy or sell.

Essentially, Select is a way to source good ideas. But Rodney is responsible for the performance of the portfolio.

Question: How do you attract new clients (is it just the word of mouth?)?

Kiel: We have attracted some great, long-term oriented institutional and family office partners over the past few years. In the beginning, though, it was all individual investors who I had some connection to. My background was as an attorney and as a soldier, not as an analyst on Wall Street. That different background has served the portfolio well but did not help fundraising in the beginning. If you are just starting out or looking to start out, the person to learn from is Rob Vinall at RV Capital. He has written some great things on the subject saying to focus on the portfolio in the beginning and allow investors to self-select to you.

Question: How do you manage your client base so that the largest investor's liquidity needs do not seriously affect the portfolio (is it just a coincidence?)?

Kiel: We have a strong foundation with more than 80 investors. No investor makes up more than 10% of the fund. And we have a nice mix of individuals, family office, value-oriented fund of funds and a few other institutional investors. All of them self-selected to Arquitos. This gives me the freedom to do some unique things in the portfolio.

Question: Are your long-term holdings more about the price or the business? Will MMA Capital Management, for example, be around 10 years from now earning much more than today or is just the price still below intrinsic value (estimated at some multiple of book value)? Are you going to sell when the two match each other?

Kiel: The long-term holdings have to be about the business. The short-term opportunity is multiple expansion. The long-term opportunity is the company effectively re-investing the cash it generates. If you can capture both, the gains can be extraordinary.

Specific to MMAC, the business has made the transition to a cash-flow generator with reinvestment opportunities. It has become much more predictable, and it is highly likely that its cash generation will increase steadily over the next decade. Hopefully, the valuation won't get so far ahead of itself that I'll be forced to sell.

Question: Arquitos has an exceptional track record, but it has been operating through the bull market of rare size and longevity. 2018 was more volatile and put pressure on results immediately. Do you think a bear market of meaningful amplitude will drag on your performance and turn investors' long-term returns more back to average?

Kiel: We had a poor 2015 and a poor 2018. 2015's results were because of a few large holdings that did not work out. 2018 was different. With the exception of one company, the operations of our holdings were strong. A few cheap things got a lot cheaper.

Westaim (WED.V) is a good example of this. 2018 was probably the best operational year it has had, but shares fell 17%. It currently trades at 80% of book value, which is really cheap. Whatever the overall market does and whether we are in a bear or bull market, Westaim is going to do well over the next few years.

If you go through our biggest performance contributors, each had its own company-specific situation unrelated to the overall markets. Whether it was ALJ, Intrawest Resorts, Sitestar, MMAC or the other large contributors, they were not tied to the bull market.

I will add that looking at things top-down can really skew the perspective as well. It has been a difficult environment for value investors for many years. Obviously there have been some specific opportunities, but I think most of us are looking forward to more market corrections so we can pull the trigger on some companies on our watch lists.

Question: Do you prefer to use asset-based intrinsic value calculations like Walter Schloss or earnings-based ones?

Kiel: Peter Cundill said that you should buy on the balance sheet and sell on the income statement. I've created a bastardized version of that called "balance sheet to income statement investing." I have trouble getting myself to buy a company when it trades at, say, 20 times cash flow, even if it is growing faster than that. But I want to own a company over a long-time period, and that's difficult to do on the balance sheet alone.

The approach I have taken is to look to buy a company when it is cheap on its balance sheet characteristics, but where it has potential to turn into a cash flow generator. To do that, you have to follow the incentives and make a judgement on the capital allocation skills of the operators. I am comfortable with not having clear visibility on the future income statement as long as there is a good amount certainty on the downside on the balance sheet. We've got to have income statement potential, though, and I have to have confidence that the cash generated won't be wasted.

Question: What got you started as a value investors and do you have any book recommendations for people who aim to be like you (i.e., a top fund manager), especially for young people?

Kiel: It goes without saying that you should read "You Can be a Stock Market Genius" by Greenblatt. That was the single most influential book for me, and I apply many of the techniques he writes about.

You have to be careful in the order that you read things because you may not yet have the foundation to appreciate certain books. If you started off with "Margin of Safety" or "Security Analysis," you would be lost. You have to be ready for them.

Assuming you are ready, "Margin of Safety" is where it all came together for me. I would also read things that are on the peripheral of investing like Viktor Frankl, Alfred Adler, Walter Lippman, Ogilvey, Cialdini, etc. The goal is to improve your ability to think and make effective judgments, not just learn investing techniques that may or may not be relevant tomorrow.

One book that I rarely see recommended, but that is a must-read, is Benjamin Graham's "Memoirs of the Dean of Wall Street." It really is not about investing, but it gives tremendous insight into the way he thought.

I became a value investor because it made the most sense to me and fit my personality. Stripped to its core, value investing is delayed gratification and the refusal to blindly follow people. It's not for everyone.

Question: I would love to hear about investments that haven't gone well and why. It would be very educational (e.g., ALJ Regional Holdings (ALJJ) or SWK Holdings (SWKH))? Not sure if you had exited positions before they slumped (you very well may have made money), but they are down from 2015 when you wrote of them as good investments.

Kiel: I have gotten into trouble when a company had too much debt. If you couple debt with a difficult or unpredictable industry, things can really go south.

SWK was not a mistake, per se, but the results were not great. I was lucky to sell with only a small loss though. This was a specialty finance company led by an activist investor and senior leadership appointed by that investor. It had tax benefits and a sound strategy. Ultimately the execution was lacking during the time period that I owned it. In that situation, all of the incentives were in place for it to do well, but the results did not work out.

The lesson is that you are going to swing and miss occasionally. The goal is having a high slugging percentage, which comes from making your highest conviction companies your largest holdings. You want to learn lessons from your mistakes, and from the mistakes of others, but you also have to be careful not to overcorrect. Sometimes things don't work out and there is nothing you could have done about it. That's why not buying on margin is important, as well as having the willingness to change your mind.

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This article first appeared on GuruFocus.