INCANDESCENT CAPITAL

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

February 6, 2015

Dear Investori:

Our portfolio rose 1.46% in December of 2014 versus the S&P 500‘s decline of -0.25%, bringing

our full year (unaudited) return to 5.31%. This compares to the S&P 500‘s gain of 13.69%. The

table and charts below include other performance figures:

Incandescent S&P 500 Difference

2014 Year to Date 5.31% 13.69% -8.38% Since Inception (24 Months) 69.21% 50.42% 18.79% CAGR 30.08% 22.65% 7.43%

(6.00%)

(4.00%)

(2.00%)

0.00%

2.00%

4.00%

6.00%

8.00%

10.00%

12.00%

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

Last 12 Monthly Returns

Incandescent S&P 500 Total Return

0.00%

10.00%

20.00%

30.00%

40.00%

50.00%

60.00%

70.00%

80.00%

Jan

-13

Feb

-13

Mar

-13

Ap

r-1

3

May

-13

Jun

-13

Jul-

13

Au

g-1

3

Sep

-13

Oct

-13

No

v-1

3

De

c-1

3

Jan

-14

Feb

-14

Mar

-14

Ap

r-1

4

May

-14

Jun

-14

Jul-

14

Au

g-1

4

Sep

-14

Oct

-14

No

v-1

4

De

c-1

4

Returns Since Inception

Incandescent S&P 500 Total Return

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Although Incandescent Capital was only officially launched in 2013, I have personally managed

money for friends and family since 2009. Gross returns (unaudited) from my personal reference

account (where I keep 95% of my net worth) since then are thusly:

Return 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%

CAGR 23.84% 17.20% 6.64% 3.00% 20.84%

And here is how $100,000 would have compounded versus those two benchmarks if it was

invested at the end of 2008:

All figures above are gross of fees (that is, before any fees are deducted). Since each investor in

Incandescent Capital has the option to negotiate different fee arrangements, net returns will

vary. For 2014, if you elected our standard 20% performance fee (no hurdle, no management fee)

arrangement, your net return would be around 4.25% compared to your gross return of 5.31%.

Also, depending on when your account was on-boarded, your results may differ from the main

reference account reported above. It takes a bit of time to sync each account to the same

exposure as I buy/sell according to the ebb and flow of the market. As always, your patience is

asked for as I build your new portfolio up, but rest assured: what you own, I own. I am

committed to eating my own cooking2.

1 This is the HFRX Global Hedge Fund Index, a widely used index to praise or pan hedge funds in the press. 2 The main reference account statement is available upon request from any investor.

$360,643

$259,098

$119,372

$100,000

$150,000

$200,000

$250,000

$300,000

$350,000

$400,000

2008 2009 2010 2011 2012 2013 2014

Incandescent S&P HFRX

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Contents

2014 In Review .................................................................................................................... 4

―A Sense Of Permanence‖ .............................................................................................................. 5

The World‘s Greatest Stock Picker ................................................................................................ 6

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

United Insurance Holdings ................................................................................................. 8

―Billy‖ ................................................................................................................................... 9

Special Situations .............................................................................................................. 10

HC2 ............................................................................................................................................... 10

Sidebar: Buffett’s Cocoa Bean Arbitrage ................................................................................ 11

Metro Bancorp .............................................................................................................................. 11

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

Mistakes ............................................................................................................................. 13

A New Hope, Revealed ...................................................................................................... 15

Outlook .............................................................................................................................. 16

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2014 In Review

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

As of the end of 2014, cash (that lime-green beveled slice) was 20.6% of our total portfolio, our

biggest ―position‖. Our biggest non-cash position accounted for 14.6%, and our top five non-

cash positions occupied 52% of our total portfolio.

In the light of conventional asset management dogma, we've had a mixed year. We trailed the

S&P 500, but we beat the Russell 2000 small cap index (whose members constitute the majority

of our fund3) and the HFRX Global Hedge Fund index. Notably, we generated our returns

holding above average amounts of cash, a tactic I do not regret given the limited investment

opportunity set currently presented by the market.

As I‘ve written in several letters throughout the year, the S&P 500‘s performance can be a

misleading indicator of economic health and confidence. Investors bid up large caps far in

excess of small caps, a sign of fear and a decreased appetite for risk. The index‘s slow grind

upwards was punctuated by several episodes of extreme volatility, bringing to mind a game of

musical chairs whereby once the music stops (i.e. the market‘s uptrend is broken), traders

scramble for an open chair (i.e. the sell-sell-sell button). Interest rates on the 10-year U.S.

Treasury Bond, predicted by the vast majority of ―experts‖ to rise by the end of the year, instead

declined from 3% to 2%. Ask yourself, if the global economy is on such solid footing, why would

anyone accept a 2% return for 10 years?

3 Some have questioned why I insist on comparing our numbers to the S&P 500 when arguably our portfolio

constituents more frequently come from the Russell 2000. The reason is most of Incandescent Capital’s investors would probably be putting their capital into SPY or a low-cost index fund that replicates the S&P 500 if they did not choose to invest in me (and it is what I would suggest to them as well). The more “sophisticated” investors can easily compare my numbers to whatever benchmark they desire.

14.6%

10.6%

9.4%

8.9%

8.5%

20.6%

Position Size by %

Cash

16.0%

84.0%

Geographic Split

Canada USA

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It was a strange year indeed, one which featured conflicting signals and dead-wrong

expectations from the ―experts‖. So much so that financial commentator Josh Brown ran a piece

in Fortune titled 2014: The year that nothing worked4:

Utilities, a sector that underperforms during periods of rising interest rates and

economic growth 5 , instead outperformed and returned 23%, second only to the

healthcare sector (another defensive sector). Yet, ―every single Wall Street economist had

called for higher rates at the start of this year and 67 of 67 economists surveyed by

Bloomberg concurred.‖

―Rounding out the top-performing sectors of 2014 was an unlikely pair: tech (+16%) and

consumer staples (+13.2%)—the most aggressive and most defensive areas of the market,

running side-by-side toward the finish line, with confounded spectators struggling to

concoct a narrative for this. Why would the least cyclical sectors—healthcare, staples and

utilities—lead the markets in a year in which unemployment plummeted and GDP

growth gained momentum?‖

―Only 30% of S&P 1500 stocks posted gains exceeding the index itself. You‘d have to go

back to 1999 to see anything like this.‖

“A Sense Of Permanence”

None of the above should be interpreted as an excuse for us lagging the S&P. Bluntly, our

returns last year was dissatisfying. However, you may remember my annual letter last year

wherein I laid out my primary long-term goals for Incandescent Capital:

1. Do not lose money

2. Outperform during bear markets

3. Outperform over a multi-year horizon

The critical definition to grasp is long-term. If there is one aspect of my investment process that

has evolved, it is an ever increasing focus on looking many years ahead. It means when I invest

in a security, unless it is a special situation with defined catalysts happening within a specific

time range or a piece of distressed debt with a fixed maturity, I am anticipating our likely

holding period to be multiple years with the hypothetical intention of possibly forever. It is what

Lawrence Cunningham calls a sense of permanence6, a phrase he uses to describe how Buffett

has built Berkshire Hathaway to endure long after his own lifespan.

Truly long-term thinking is a novel concept. Wall Street, to the contrary, insists on judging on

much shorter durations. Quarterly reports. Monthly numbers. Daily P&Ls. Fundamentally,

there is no difference between a privately held business versus a publicly traded one... except the

4 http://fortune.com/2014/12/24/investing-year-review/ 5 Why? Utilities are regulated enterprises with monopolistic earnings power and typically provide stable dividend

checks to investors. That makes them bond surrogates. And bond prices go down when interest rates go up. 6 http://www.valuewalk.com/2014/10/berkshire-beyond-buffett-book/

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value of public companies fluctuate by the nanosecond. Trading activity has increased to

ludicrous levels of fury, and almost completely controlled by computers to boot. It is, of course,

nonsense. Businesses take time to execute strategies, to hire people, to accumulate working

capital, to close sales, to build a reputation and a brand. To judge a business on how its stock

writhes and twists under the control of competing computer algorithms is obviously folly. And

yet, our emotions rise and fall commensurate with how our stocks wiggle up or down. We simply

cannot help it.

The World’s Greatest Stock Picker

Last October, Barry Ritholtz published a column in the Washington Post7 with this tantalizing

lede:

―Let‘s imagine for the moment that you are the World‘s Greatest Stock Picker. You have

an uncanny talent for ferreting out the next Microsoft — companies that are on the

sharpest edge of what‘s next, that are about to undergo tremendous growth.‖

Using the five most well-known stocks that have returned over 1,000% to-date since their IPOs

as an example, Mr. Ritholtz takes us on a trip down memory lane. Remember when: Netflix lost

41%... in one day? Chipotle lost 76% during the Great Recession? Apple‘s stock got cut in half in

one quarter? In one month? In one week? All true stories. How many of us could stomach that

level of volatility and actually reap the 1,000% return, even if we could identify those incredible

stocks in the first place?

The rejoinder: ―Your superpower gives you the ability to find the giant winners, but it does not

give you the ability to hold onto them.‖ It is a brilliant piece that suggests perhaps the true

superpower then lies not in stock picking but in the ability to endure the nonsensical volatility

that surround the public markets, to abide by the fundamentals of the business, to keep one‘s

vision on the long-term.

And so it is from this perspective that we should use to judge our results. Instead of just looking

at how our stocks performed in the market, which, as Keynes has quipped, is basically like a

beauty contest, we should ask questions like: How did our businesses operate over the course of

the year? Did their earnings power grow or shrink? Did they maintain the value of their assets?

Are they taking undue risk with their balance sheet? Did their managers allocate capital in a

responsible manner?

In that context, I am much more sanguine about 2014. I made mistakes—which I will openly

discuss later on—but none that did permanent damage. All of the names in our portfolio

continue to check ‗yes‘ to most of those questions above. Some of their stock prices moved to

reflect that, and some did not. Most importantly, I have developed several new ideas that should

bear fruit for us in 2015 and beyond.

Now let‘s talk stocks.

7 http://wapo.st/1vjFMik

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Yellow Media Limited

For the second year in a row, I will begin by talking about Yellow Media (TSE: Y). In 2013, it

was our banner success story. Now, in 2014, I can report we‘ve booked most of the profits, the

majority of it being the more favorably taxed classification of long-term capital gains. Owing to

the fact that it tripled in 2013 and ended up as such a big position in our fund (approximately

40%) as well as for tax management purposes, I decided to sell gradually over the course of the

year. We sold over half in Q1, and then another quarter in Q2, and finally the rest in Q3.

There are several items to discuss involving such a timing and rationale. First of all, you should

know that our weighted-average cost basis was $8.11 and our weighted-average sale price was

$20.40. We didn‘t quite book the full triple, but a 2.5x return in two years on our biggest

position by far should still be enormously satisfying.

This affected our performance for the year because Y, which started the year at around $20,

spent nearly the entire year pulling back to $14 before rebounding back to the $17 range by year-

end. For investors that came onboard in the first half of 2014, that was an unfortunate headwind

to contend with. It was an admittedly thorny issue – one always hopes to make a good first

impression, but sometimes the market does not cooperate. The best I could do was to constantly

keep communication lines open and explain my rationale in real-time.

Obviously in hindsight I would have loved to have sold the entire position at its $25 per share

peak in February and immediately rotate the cash into our next best-performing idea. But

executing perfect timing in the stock market is a unicorn. The fact of the matter is Y is still a

cheap stock. It continues to trade at single digit multiples while its digital business has officially

crossed the 50% revenue threshold. Those factors alone make a good bull case for the stock even

at $20 per share.

However, the story is becoming complex. What was once a no-brainer strategy of shoveling free

cash flow towards debt pay-down is now muddied by their attempt to accelerate digital growth

by spending heavily on marketing while pulling back on reducing debt. Time will tell if their

strategy bears fruit. The plan is a long one and does not forecast overall growth until 2017. I

believe current management has their heart in the right place, but it will be difficult to grab

mindshare from the new internet darlings and whatever grounds they gain with their marketing

push will not be as defensible as it was in the days of the monopolistic yellow pages.

As such, my preference would be for Yellow Media to continue to aggressively pay down debt. A

bird in the hand is worth more than two in the bush in this case. Still, we have retained a small

percentage of our fund in Y warrants as a way to express my ambivalence. I hope they succeed

and will stand to benefit some if they do, but if they do not, we will not be significantly hurt

either.

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United Insurance Holdings

Our biggest contributor of 2014 was a name I alluded to in my July letter in a section titled A

Live Case Study of Short-Term Market Irrationality. Brief recap: United Insurance (UIHC)

is a Florida-domiciled Property & Casualty (P&C) insurance company specializing in catastrophe

risk. The company was founded in 1999 to take advantage of the Florida P&C market which was

then dominated by the state-operated Citizens Property Insurance. Political pressure forced

Citizens to begin to divest insurance policies at attractive economics to private insurers like

UIHC, a process coined ―take-out‖.

Fundamentally, the company has been on a tear. They have begun aggressively expanding their

coverage to coastal states from Texas to Maine. It has been an extremely successful campaign,

more than doubling their policies in-force and compounding their book value by 15+% per

annum since 2011. What separates them from their fellow Citizens take-out competitors is their

focus on building a quality network of agents and growing organically outside of Florida. 79% of

their Q3 growth in premiums came from outside the sunshine state.

Although we‘ve held a position in UIHC since mid-2013, initiating our position around $7 per

share, short-term market irrationality in July (and later, September) gave us an opportunity to

add to it. Despite stellar earnings, the stock sold off. There was no rational reason. Insiders even

stepped up to buy shares in the open market. As I wrote in the July letter:

Such is how irrational Mr. Market can be at times, and it is easy, even instinctive, to feel

fear in the face of a rapidly tumbling stock price. But for those who have done the

homework and possess the confidence gained through careful and thorough due

diligence, fear becomes opportunity. We upped our position in this company the next

day, which, unfortunately, make our monthly statements look bad, but has a very

probable chance of being highly profitable over time as the company continues its

upward trajectory.

We scooped up shares between $14 and $15 as did opportunistic insiders who were just as

baffled. In hindsight, it was a layup scenario. As management keeps hitting their numbers and

the value of their business rise, the market was, astonishingly, offering us an even bigger

discount. I‘m happy to say UIHC closed just shy of $22 at year-end. We continue to be very

satisfied shareholders and hope to be for years to come.

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“Billy”

Our second biggest contributor is a Canadian alternative energy company which I will demure

from revealing for now8. This company, which I‘ll call ―Billy‖, has been a staple of our portfolio

for over two years and exhibit characteristics that Buffett uses to describe an ideal business: One

that earns very high returns on capital and keeps using lots of capital at those high returns.

That becomes a compounding machine.

Billy has a long history which began as the energy arm of a manufacturing company. Over the

years it sharpened its focus on sustainable renewable energy and today own a portfolio of mostly

wind and hydro power stations. Why is this an ideal business? Because Billy has relationships in

jurisdictions that have favorable public policies towards green energy. That means their power

stations sign long-term (think 15 to 30 years) contracts with AAA-rated utilities locking in a high

enough price-per-megawatt-hour to earn a high return on their capital. They can do this over

and over again because the world has a long way to go to wean itself off of fossil fuels.9

Traditional by-the-textbook investors tend to quickly pass on the name when they look at their

financials: thin profit and free cash flow margins, highly levered. Such an assessment is a

fundamental misunderstanding of Billy‘s business. Profit margins are thin because depreciation

is the biggest ―cost‖ even though wind and hydro plants require minimal capex to maintain.

Leverage looks high but the debt is owed by each individual power plant (which is backed by

guaranteed contracts), and thus is non-recourse to the parent company. Free cash flow looks

putrid but that‘s because all the free cash is busy being spent on new projects that will spew out

even more cash.

The key metric to assess here should be operating cash flow, which reflects how productive

and valuable their growing cadre of assets are. Most investors do not realize that Billy‘s business

is comparable to a real estate investment trust or an expanding telecom company. All of these

businesses require high up-front capital expenditures but then much less to maintain once the

assets are constructed. The assets are valuable and cash generative and the high depreciation

shields much of the tax liabilities in the early years.

Billy is relatively illiquid due to the aforementioned manufacturing company who still owns over

30% of the company. Also, it trades on the Toronto Stock Exchange. Those two characteristics

keep the stock relatively off the radar of most investors and consistently cheap. That is totally

fine by us. We do not need investors to ―wake-up‖ and realize how valuable Billy is. If they do,

we‘ll probably reap a considerable immediate windfall. But if not, their asset base will continue

to compound and their cash flows will continue to increase, and the stock, even while staying

cheap, will continue to inexorably advance:

8 Why? It’s complicated. Call me if you want to know the details. 9 Buffett knows this. His Berkshire Hathaway Energy group has invested over $15 billion in renewables and he’s

been quoted saying: “There’s another $15 billion ready to go, as far as I’m concerned. It’s where the country’s going.” – http://cleantechnica.com/2014/10/12/warren-buffetts-midamerican-energy-investing-280-million-iowa-wind-farms/

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

Special Situations

Occasionally we will invest in special situations – companies that are undergoing some form of

corporate change unrelated to normal business activities. These special situations are by nature

short-term, with defined catalysts and rough timeframes in which they will (or will not) resolve.

Here is a tale of one successful, and one not-so successful special situation investment we made

last year.

HC2

In Q3, a popular write-up was passed around the investment community regarding a

construction company called Schuff. Schuff had been a family-run business for years and years

and could barely be thought of as ―public‖. It traded on the pink sheets10 and 65% was held by

insiders who never traded their shares. Then, in May, Schuff‘s biggest shareholder, Scott Schuff,

decided to sell. A deal was struck with HC2 (HCHC), a shell company owned by New York

financier Philip Falcone, to acquire his shares. HC2 proceeded to make a run at the rest of the

shares via a tender offer for $31.50 per share.

The popular play at the time was part arbitrage, part activist. Buy up shares of Schuff and force

Mr. Falcone to pay a higher price. By many metrics, it seemed like Mr. Falcone was stealing

Schuff. Construction is a cyclical business and Schuff is on the uptrend of the latest boom.

However, Schuff was extremely illiquid. Few, if any, shares were readily available on any given

day. A much easier trade, it occurred to me, was to simply buy HC2. It was also pink sheet

traded but was much more liquid. Instead of scraping for shares of Schuff and hoping to force a

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

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higher tender offer, why not simply switch teams and own HC2? You get better economic

benefits than owning Schuff due to the NOLs HC2 has stashed away11, and then further technical

upside if HC2 uplists to a national exchange and improves their visibility to mutual funds and

other large investors.

We bought shares of HCHC at around $4. By October, Falcone successfully squeezed out the rest

of the shareholders and completely took over Schuff and HCHC traded up to $5.50 per share.

Then the company announced they are uplisting to the New York Stock Exchange and shares

reached $8. We exited this trade at $7.66 in December, banking quite the IRR for our buck.

Sidebar: Buffett’s Cocoa Bean Arbitrage

Our HC2 trade was inspired in part by the story of when Buffett was a young man and

worked for his mentor Ben Graham. Graham had come upon a situation where a

company called Rockwood was trading its inventory of cocoa beans for shares of its

stock. To incentivize the trade, Rockwood offered $36 worth of cocoa for $34 worth of

stock, a surefire way to bank $2 per transaction. Buffett managed this near risk-free

trade for Graham… but for himself, he bought shares of Rockwood and just held on to

them. He correctly figured that if Rockwood was so desperate to do this trade, the true

upside was in actually owning the company rather than the cocoa beans. And guess

what? Rockwood shares went from $15 to $85. It was an extraordinary example of

inverted, simple big picture thinking that eludes even the most intelligent of investors

who can be seduced by fancy complex situations that offer only limited upside.

Metro Bancorp

Our less-than successful special situation is not nearly as complex. In June, we initiated a

position in a community bank holding company called Metro Bancorp (METR) at around

$22-$23. Metro was a former franchise of the successful Commerce Bank (now owned by TD

Bank), whose model was unprecedented levels of customer service. Walk into a branch and be

greeted as a ―guest‖ rather than a ―customer‖. Free candy and coffee while you wait for a

representative. Open 7 days a week. Customers loved it and poured deposits into the bank,

creating an enviable core deposit base that basically amounted to extremely cheap money for the

bank to lend out.

However, we no longer live in a world where such a model is as attractive due to the financial

crisis and the proceeding low interest rate environment. Banks can no longer lend at high

enough interest rates, nor an aggressive enough leverage ratio to offset fixed costs such as fancy

branch service and generate an acceptable ROE for their shareholders. Several activist investors

piled into Metro and began clamoring for a sale of the company to a bigger bank who can better

leverage their attractive core deposit base.

The bet was simple. If the activists succeeded in completing a sale, we would have a nice windfall.

If they don‘t, we exit with hopefully minimal losses. My research indicated there were interested

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

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suitors for Metro, with the only question being whether its management would be willing to

maximize shareholder value or would rather hold on to their jobs and continue to enjoy their 3-

6-3 lifestyle12. By October, we had our answer: the latter. As a token compromise, management

offered to initiate a small dividend and share buyback program and promised to cut costs. The

activists were not pleased and is seeking to infiltrate Metro‘s board. Anyway, that‘s not what we

signed up for, so we exited shares at $23.16 for, luckily, no loss whatsoever.

Cash Proxies

In last year‘s letter I talked about the idea of ―cash proxies‖ – securities that I deem safe enough

to park our excess cash and are liquid enough to trade out of should a better opportunity

suddenly present itself. Cash proxies typically have some traits that make me believe their

downside, even in the short to medium term, is limited.

Dillard’s (DDS) was an early name we rotated some of our Yellow Media profits into. For most

of the 2000s, Dillard‘s was an underperforming retailer with undifferentiated offerings and

gaggle of underperforming stores. After the Great Recession, management got religion and

cleaned up its basic business fundamentals – better inventory management, shut down

underperforming stores, improved working capital, etc. Most remarkable was what they did with

the sudden growth in excess free cash flow: they bought back stock. From 2007 to 2013, share

count was reduced from 79 million down to 46 million, a reduction of 42%.

Whoever believe share buybacks are useless never invested in DDS because the stock went from

$4 in 2009 to over $100 in 2014. That‘s a 25x return – a 70% CAGR, folks! – from a sleepy

department store with no presence in L.A., San Francisco, Chicago, or New York that shrank its

footprint during that time frame! We caught the tail-end of that run after management

announced (surprise surprise), yet another share buyback, and rode DDS from $90.72 to

$109.70.

Supremex (TSE: SXP) was a tip I got from Guy Gottfried‘s presentation at the 2013 Value

Investing Congress13. The company is the largest manufacturer of envelopes in Canada. Plainly,

a dying business. But as Howard Marks often said, there are no bad assets, only bad prices. And

SXP sported a very nice price indeed: 4x free cash flows (FCF) and a 7% dividend yield that

represented only 25% of its FCF. Basically, it was trading at a price that would be overwhelmed

by its free cash flows in just a few years. Scenarios like Supremex, however, can become value

traps if management is filled with the illusion that they can turnaround the business by

―investing in growth‖. Luckily, adult supervision was present in the form of Clarke Inc, an

investment holding company controlled by savvy investor George Armoyan which owned 45% of

SXP. We initiated a small stake (perhaps too small) at $1.80 and exited at $3.04.

12 An old banking joke: borrow at 3%, lend at 6%, hit the golf course by 3pm. 13 Long-time readers will recall we also plucked an idea from Mr. Gottfried in 2012, The Brick, which also doubled.

At this point, whatever Mr. Gottfried publishes, I make sure to take a long, hard look.

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Our final cash proxy was mentioned in my August letter – Apple (AAPL). While typically

mega-cap companies are not where one would likely find inefficiencies to exploit, Apple is a

unique stock due to its mystique and the fact that everyone has an opinion on the company. Do

you remember AAPL being nearly cut in half from late-2012 to mid-2013? That typically do not

happen to ‖efficient‖ stocks with hundreds of billions in market cap. However, similar to

Dillard‘s, management got religion with regards to capital allocation. Its dividend was raised,

and titanic share buybacks were announced. In May 2014, CEO Tim Cook anticipated returning

$130 billion to shareholders. Those are record breaking figures, and it telegraphs the fact that

Apple will be aggressive with regards to buying its own shares in the open market. Basically, a

floor for the stock was put in. We started buying shares around $86 and sold them at $96 a few

months later when more attractive opportunities presented themselves.

Mistakes

Mistakes are inevitable when investing. That‘s because investing is, at its essence, an attempt to

predict the future. For stocks, we‘re trying to guess at future cash flows, which depends on

industry dynamics, management, financial health,. etc., and compress all that information into

one number: the stock price. This is not a game anyone gets ―right‖. This is a game of odds.

Two mistakes stood out last year. The first with which I will flagellate myself with is Roundy’s

(RNDY), a grocer in Wisconsin and Chicago that, in hindsight, fits into the old Charlie Munger

aphorism: if you mix raisins with turds, you still have turds. This was a clear unforced error by

your humble investment advisor. Roundy‘s has a long history as the dominant grocer in

Wisconsin. They were taken private in 2002 by Willis Stein & Partners and re-IPO‘d in 2012 to

much… ado about nothing. RNDY had hoped to open between $10-12 per share but instead

printed at $8.50.

Roundy‘s had several things going for it that attracted my interest. 1.) A busted IPO typically

leaves behind disillusioned investors and a depressed stock price – fertile hunting grounds for a

value investor. 2.) Bob Mariano was brought on by Willis Stein to be CEO. Mr. Mariano had a

distinguished career at Dominick‘s, eventually selling it to Safeway in 1998 for $1.2 billion. 3.)

Mr. Mariano began to launch a new store brand in the Chicago area called Mariano‘s which, by

all measures, is a major success and has a long runway for growth. I began to draw parallels to

Mickey Drexler‘s career arc, who came to fame by growing The Gap and returning for an encore

with J. Crew, a successful investment of ours in 2010.

The stock was cheap because even though Mariano‘s was doing gangbusters, their legacy

Wisconsin stores, suffering from years of under-investment, was getting their lunch eaten by

competitors. However, I calculated that RNDY‘s valuation had it fully discounted – it could be

argued that Mariano‘s is worth the entire market cap of RNDY alone. Mr. Mariano has

continually promised to turn Wisconsin around. If Wisconsin stabilizes, RNDY could be an easy

double from our cost basis of around $7.

Unfortunately, quarter after quarter, Roundy‘s missed their numbers. It was comical in a sad-

clown kind of way. It became clear that management was really only interested in Mariano‘s

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growth in Chicago. When Safeway announced they were divesting a bunch of old Dominick‘s

stores, Roundy‘s issued expensive debt and equity to buy them up and convert into Mariano‘s.

Meanwhile, their comparably generic Wisconsin stores languished. Same store sales continued

to decline and eventually dragged what was once a profitable, dividend-paying enterprise into

the red ink of quarterly losses. Their CFO quit for a better opportunity at Rite Aid.

While it‘s still possible the rapid growth of Mariano‘s in Chicago could pull Roundy‘s out of its

tailspin, I threw in the towel in June, selling our shares around $5. Perhaps there will be a way

to isolate the Mariano stores from the declining Wisconsin stores – perhaps through a sale,

although it seems unlikely because why buy up your competitor when you can just compete it

out of existence? – but the bond holders will be ahead in line to capture the value. When you

mix raisins with turds, you still get turds indeed.

The other mistake is Danier Leather (TSE: DL), a small Canadian retailer that practiced

excellent capital allocation but did not move fast enough into the internet shopping and big data

era. Danier is an old idea that was already part of Incandescent Capital‘s portfolio before I began

taking outside investors. We began building the position in 2011 and continued to peck at it

occasionally throughout 2012 and 2013. Our average cost basis was $11.45. The thesis behind

Danier was fairly simple. They occupied a niche with a relatively recognizable brand within its

market and its management has proven to be shareholder friendly in the past when they bought

back boatloads of stock during the Great Recession which propelled their stock from $3 to $14

per share between 2009 and 2011.

Unfortunately, Danier did not keep up with the times as consumers changed their shopping

habits. They weren‘t equipped with proper analytics and ended up stocked full of unpopular

assortments. All the excess inventory over the holidays led to big discounts and crushed margins.

It‘s also likely that management overestimated their pricing power as consumers have grown

increasingly sophisticated by learning to price-check everything online. Speaking of online,

perhaps most damning was their lack of an eCommerce presence. As late as Q2 2014, they were

still relying on catalogs while trying to launch a workable eCommerce site. That strategic error

led to untold amounts of missed sales opportunities as a brutal winter encouraged most

consumers to shop from the comfort of their couches.

I sold out of DL at an average cost basis of $7.40. Looking back, there was little indication that

Danier Leather would end up this poorly. It was once a quality business helmed by managers

who owned tons of shares and practiced good capital allocation. But it was overwhelmed by the

tidal wave of change brought on by the digital era. Very few legacy retail companies has had the

foresight to shift strategically with enough speed. This was a defensible error but an error

nonetheless, i.e. it‘s probable that mistakes like Danier Leathers will happen again in the future

– the key is to not have it hurt too bad. In the latter‘s regard, I did a passable job. Danier Leather

was kept at a relatively small size and the returns from our cash proxies over the years more

than offset the losses from DL.

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A New Hope, Revealed

In the New Hope section of my Q2 letter, I hinted that I found what I hope will be our next long-

term winner. With a position fully built, I can reveal that it is BlackBerry (BBRY), currently

one of our largest holdings. We began buying in the $7s but have continued to accumulate as it

whips around and currently sit on a cost basis of $9.29 per share.

It is a turnaround play that is widely misunderstood. Like Apple, everyone has an opinion on

BlackBerry. The prevailing opinion continues to be that their handsets should be relegated to the

history books – once iconic but, like Polaroid and Zip Drives, have no hope of capturing past

glory. Funny thing is, I actually agree with that assessment. What I disagree with is that fact will

doom the company.

BlackBerry has several key assets that are very difficult to replicate. One is their Network

Operations Center (NOC), which is essentially a global VPN hooked up to hundreds of wireless

carriers around the world. BlackBerry‘s NOC was originally built out to do a lot of the behind-

the-scenes heavy lifting back when data transfers were very expensive. Today, its NOC is the

bedrock of its new pitch: security. Once a data packet is routed from the carrier into the

BlackBerry NOC, it‘s effectively firewalled from prying eyes. By contrast, a regular cell phone‘s

data packet would hop around various networks controlled by multiple entities before reaching

its destination. It‘s like getting into a bulletproof car you trust and driving to your destination

versus hitch-hiking your way there. These days, with reports of new corporate hacks happening

with increasing regularity, that trip is growing akin to traversing through Daesh-controlled

regions of Iraq.

Another asset is QNX (pronounced Q-NIX because it‘s a Unix-clone). QNX was originally

acquired by BlackBerry in 2010 and its codebase was forked to build the operating system

running in the newest BlackBerry 10 handsets. It is a supremely stable OS because it is

microkernel based, meaning critical processes are run as siloed tasks and do not crash the entire

system if one of them misbehaves. This is an important difference because both Android and

iOS are run on versions of Unix (Linux and BSD, respectively) that are less stable (but more

efficient) monolithic kernels. Because of its stability, QNX has also been forked to become the

underlying OS that manages most of the software in modern cars. But wait, why stop there? Its

flexible microkernel architecture allows it to be customized for any connected object. As the

Internet-of-Things (IoT) phenomenon grow to link almost everything in our daily lives into the

cloud, expect QNX to play a significant role.

The crown jewel is their newly launched BES 12 enterprise server, a Swiss Army Knife solution

built to manage any and all handsets, including Android and iOS. This is a life-saver solution

for CIOs who are struggling with corralling all the personal mobility devices intruding into the

corporate LAN. Furthermore, BES 12 is the gateway to the BlackBerry NOC, which opens up all

kinds of possibilities that the company is just starting to explore. Example: VPN authentication.

No longer do employees need to lug around an expensive RSA tokens when traveling – they can

simply authenticate their identity using their cell phone if it‘s connected to BES 12 via the

BlackBerry NOC.

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Overseeing all of this as Chairman and CEO is John Chen, one of the most respected executives

in tech who was lured to the job by Prem Watsa when Watsa‘s FairFax Financial led a group to

save the company with a billion dollar injection. Chen‘s C.V. includes previously turning around

Sybase and generating a 28% CAGR over 12 years when it was ultimately sold to SAP. Chen also

sits on the board of Wells Fargo and Disney and is a trustee of Caltech and the think-tank

Brookings Institution and was senior advisor of $23 billion tech-focused PE firm Silver Lake

between his Sybase/SAP and BlackBerry gigs, et cetera, et cetera. The point is, John Chen has

been around the tech rodeo and, also, powerful people will return his messages.

I haven‘t even mentioned BBM nor BlackBerry‘s patent portfolio nor their existing relationships

with 40,000 businesses around the world. The company today is so much more than a handset

maker. The crux of our investment in BBRY hinges on Chen tying all of those assets together and

transforming the enterprise into something like the Cisco of the mobile world, the guys who can

offer all the behind-the-scenes plumbing as more and more data travel across radio waves.

Those assets are real, even though traditional accounting cannot put a valuation on them, and

thus, BBRY continue to languish with a fraction of the enterprise value (which includes almost

$2 billion in net cash) afforded to tech companies sporting such treasure troves.

However, it is a volatile stock, popular with day-trading rumor mongers and the financial media,

and so I feel the responsibility to detail our ownership if/when it causes material ripples in our

monthly results. I believe time will monetize their assets, but if not, there are others who will

happily try as incessant rumors of big tech companies itching to scoop them up for cheap

circulates regularly. In a fire-sale scenario, BBRY shares are likely worth somewhere in the low-

to-mid teens today. That‘s the downside. As one big functional unit on the vanguard of the IoT

revolution, it could be worth multiples over time. We are rooting for a John-Chen-special 28%

CAGR over another dozen years.

Outlook

The bull market reached its sixth year in 2014 despite showing some noticeable cracks during its

ascent. It is my opinion that the broad stock market continues to be fully valued. The S&P 500‘s

forward P/E ratio has hit 16.6 times, which, according to FactSet, is its highest since 2005. Of

course, the interest rate environment today is completely different. My feeling can probably be

colloquially described as kind-of-expensive-but-not-insane. In other words, I have no idea how

the S&P will perform this year. I feel fortunate I am not a macro trader.

But as I review our overall portfolio, the phrase that leaps to my mind is: ―hard to lose‖.

BlackBerry is not yet at a size that disproportionately outweighs every other name, and I do not

anticipate building it to the size of Yellow Media back in 2013 because it certainly involves

execution risk. It can be thought of as a bundle of near-free call options that could be worth

multiples in the future while, buffeting its volatility, sleepy stable compounders like ―Billy‖ and

UIHC and a couple of other undisclosed names round out our top positions.

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We remain relatively concentrated because, quite frankly, it‘s tough to find good ideas. However,

literally 95% of my net worth is invested alongside yours, so constructing a portfolio that allows

me to sleep well while feeling excited about its prospects is my day-in-and-day-out obsessive

concern. That is one constant you can always count on. Investing is not just a job for me, it is my

raison d'être and a wellspring of purpose and joy. I tap dance to work and feel humbled and

grateful to all my investors who enable me to do what I love every day.

As always, I welcome any questions and/or feedback. I wish you and yours a prosperous and

joyous new year.

Sincerely,

Eric Wu

i The information set forth herein is being furnished on a confidential basis to the recipient and does not constitute

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