Beating the Market With Arquitos

Steven Kiel looks for multi-bagger opportunities from balance sheet to income statement valuation and beyond

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Hugo Roque
Jan 17, 2020
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Steven Kiel is the founder and Chief Investment Officer for Arquitos Capital Management. He is also the portfolio manager of Arquitos Capital, a value-oriented private investment fund. Since starting in 2012, Steve has achieved returns of 16.9% annually after fees, beating the market’s return by almost 4% per year on average. A rare breed nowadays! He follows a focused investment strategy with careful downside management and potential multi-bagger exposure.

Roque: You defend that you invest in balance sheet to income statement companies. What do you mean by that?

Kiel: The idea is to buy on value and hold for growth. I am looking for companies that are in transition that can be bought when they are cheap on balance sheet metrics. These companies also need to have characteristics or incentives in place that give them the potential to profitably reinvest into their operations. If that transition is successful, then there is a good chance that a company can become a multi-bagger.

For example, let's say you bought a company near book value with a strong balance sheet and a low amount of debt. You get some downside protection from that. If that company has a unique opportunity to use their balance sheet strength to profitably grow their business and generate free cash flow over time, then you will have gotten access to that growth as an investor very cheaply. You have to be patient and accept some uncertainty about the chances of that transition, but you get protection due to the strong balance sheet. The reason why these can become multi-baggers is because once the company shows it can produce predictable cash flow, it will get valued by other investors by its income statement metrics such as an earnings or cash flow multiple. Its price to book, for example, then is much less important. Balance sheet investors then leave and income statement investors come in.

Roque: You find opportunities in the public markets through intensive research and extensive relationships. Can you give some examples that illustrate the level of detail that you can go researching a stock?

Kiel: First, there is an incredible amount of information available from original sources, i.e. the SEC filings. My background is as a lawyer, so going through S-1 and S-3 documents can sometimes yield some unique information. I have also found fruitful information from reviewing employment contracts from senior management. These are often filed as well. Reading through compensation packages for a COO [Chief Operating Officer], for example, can provide important clues as to what the board is focused on. Reading through loan contracts, which are also generally filed, can help to highlight some potential risks.

Second, when you are dealing with smaller companies, making contact with management and other large shareholders is important. If you have a widely diversified portfolio you can take a more quantitative approach, but if you make large, concentrated bets like I do, then you need to get a comfort level with the decision-makers. This might mean getting to know a director, having regular meetings with management, going to the annual meeting, talking with competitors and all of that scuttlebutt. Just be wary of them selling to you. CEOs often get to their position because they are highly optimistic and persuasive. Keep that in context. And, when you're doing research, don't harass these people. If the company is small, their resources are finite. Wouldn't you rather have the person be doing their actual job rather than speaking to a small time investor?

Most importantly, though, you want alignment with the major decision-makers at the company. You want to see large insider ownership and a demonstrated record of the company looking out for all long-term shareholders.

Roque: Arquitos' top five holdings often account for up to 75% of the fund. What does that imply in terms of risk management?

Kiel: These are companies that generally have a low amount of debt and where the risk of permanent capital loss is minimal. Our top five holdings all trade below book value and all but one have very little or no debt. None of those five positions are correlated to each other by industry or the overall markets themselves. This concentration can lead to more volatility in the stock price, but if the companies are doing well operationally, then that volatility can be a real opportunity. If you take a concentrated approach like this, you cannot buy on margin because in the short-term anything can happen in a stock price even if operations are going well.

Roque: You tend focus on the small, illiquid, most ignored segments of the market. Do you think it’s harder to outperform with the larger, steady, more screenable opportunities?

Kiel: I wouldn't say that I focus on small and illiquid. I have also had success with larger companies going through transitions. For example, I did well owning Iron Mountain (IRM) when it did a REIT conversion some years ago. I've owned the Bank of America (

BAC, Financial) TARP warrants. I owned Phillips 66 (PSX) during its spin-off. Intrawest Resorts was a $1 billion company when it got bought out. I'll follow the opportunities as they come. Right now the really low-risk opportunities are in a company like MMA Capital (MMAC, Financial) and Westaim (TSXV:WED). Last year I looked seriously at KKR and Brookfield but ultimately did not invest, to my detriment. You don't need to run a screen to learn about their value.

Roque: Your largest position is in MMA Capital. Can you describe your investment thesis for this company?

Kiel: Sure. MMA is a specialty finance company focused on providing debt in the solar lending area. They have made a transition over the past eight years from a company with a hodgepodge of assets into a company that now manages a relatively predictable portfolio. The thesis in a nutshell is that the stock trades for 15% below book value with massive buybacks below book over the past eight years, high and active insider ownership, and tax benefits where they will not be paying federal taxes for the foreseeable future.

They have yet to have a loss in their solar lending fund and recently surpassed $2 billion in originations. They have made 17% IRR on the loans, so this has proven to be a very attractive business. They are also sitting on a large pile of cash. MMA's results have not been, and likely won't, be correlated to the overall economy and general stock market returns.

Roque: How important is the alignment of incentives for the success of your strategy?

Kiel: Alignment is the most important thing. We need it at every level. I am aligned with my investors by having most of my net worth in the fund. We need the companies that we are invested in to have alignment with our interests, as minority owners of that business. I look for high insider ownership and active share buybacks when done at attractive prices. Prior to launching Arquitos, I was an attorney and often participated in corporate investigations. Reading internal communications from executives about how they run the business and what they value was, in those situations, quite scary. No matter how well-informed you are as an investor, there is so much you will never know about the inner workings and attititudes of decision-makers of the company. The best thing you can do to ensure they are also looking out for your interests is to be in a situation where their interests overlap with yours. That means that the key decision-makers are also significant shareholders.

Roque: You have given examples of investments that could be classified as Generals (undervalued stocks) and Workouts (special situations), by Buffet's partnership terms. However, you also do Controls (activism). How do you think these separate categories help you to more effectively manage your portfolio?

Kiel: Being willing to invest in each of those categories gives you an opportunity to take advantage of a variety of market situations. At times there may be more special situation opportunities, for example. Other times, you may have better opportunities in buy and hold securities that are undervalued. You have to constantly compare your opportunity set. Ultimately investing is about comparing risk and reward across opportunities. Arquitos does have a control position in a company, but this is not something I would recommend to other funds unless that is your fund's primary strategy. Taking a more holistic approach like this always gives you something interesting to do and can allow you to broaden your opportunity set, especially during time periods where the markets are overvalued.

Roque: On you last Investor Letter you have said that you are seeing "the largest discrepancy between share price and intrinsic value for the portfolio" since you launched the fund. Why do you think that is happening? Do you see the market today as more unbalanced?

Kiel: Traditional value has been out of favor. The market is not currently rewarding companies with strong balance sheets and a low amount of debt. The market is also not rewarding smaller companies right now, and most of my larger positions are smaller companies. Low interest rates and low inflation certainly affect where money goes in the markets. There always has been and always will be ebbs and flows. Traditional value investors should not lose hope and capitulate. As someone who is more focused on special situations, one stock in the portfolio can have a hugely outsized effect on the overall results so I don't focus too much on the entire portfolios metrics. However, if each of our top five holdings was liquidated, we would have significant gains.

Roque: Could you share some of the mistakes that you have made over your investment career and what you have learned from them?

Kiel: It is important to consider mistakes of omission as well as mistakes of commission. The only thing you can do with mistakes of commission is objectively analyze why it happened and work to prevent it in the future. Typically, the issue is staying disciplined. My mistakes there are generally from getting overly excited about a company or situation. Heck, I owned JC Penney at one point!

Don't forget to objectively analyze mistakes of omission. I had a big one last year with a company named Belmond that was bought out by LVMH. My close friend, Thomas Braziel of 507 Capital, presented this idea to me on a silver platter. I looked closely at it. The situation fit all of my requirements and the likely outcome was clear. Unfortunately, I did not act to my huge detriment. It's important not to dither. When you have a huge opportunity, you have to act. That's part of being disciplined as well.

Roque: Can you give us a book or article reference that most value investors don't mention but that you find to be particularly enlightening?

Kiel: I recommend Ben Graham's memoir. It is not focused on his investing career, but it gives tremendous insights into the way he thought.

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