Exclusive Interview with Allan Mecham

We recently had the pleasure of interviewing Allan

Mecham who heads Arlington Value Management. The
firm has established an impressive ten-year record,
including a positive return in 2008 despite no reliance
on short selling. We are pleased to bring you this
interview exclusively in Portfolio Manager’s Review.

Allan Mecham
The Manual of Ideas: Over the ten years ended Arlington Value
December 31st, 2009, the S&P 500 delivered an
underwhelming return of negative 9.1%, equaling a
1.0% annual loss. Bruce Berkowitz’s Fairholme Fund achieved a net annualized
return of 13.2% during the same period, while your fund returned 15.5%
annually net of fees. Berkowitz’s record has made him somewhat of a “rock
star” in the investment business. How come you are still flying below the radar?
Allan Mecham: Ha! Good question… I’m eagerly awaiting The Little Book on
“Taking emotion out of the Becoming a Hedge Fund Rock-Star. In all seriousness, it’s likely a combination
equation, or at least of factors (Salt Lake City-based LLC, only $10+ million under management for
minimizing it as much as the first five years with no serious marketing), but certainly my limitations
possible, is vitally important marketing Arlington are partly to blame. Additionally, and probably the biggest
and difficult to do if you have reason for our obscurity, stems from our fanaticism about accepting the “right”
investors peering over your capital. Maintaining a culture that’s conducive to rational thinking and
shoulder in real time, investment success has been the top priority since inception. We have turned
down significant sums of money on many occasions because of this stubborn
questioning ideas.”
commitment. As I said in my most recent letter, we get far more satisfaction
from producing top returns than from the size of our paycheck… though we’re
hopeful this distinction won’t need to be highlighted for much longer!
Many potential investors require monthly transparency into the portfolio
and are overly focused on short-term results. Accepting “hot” money would
endanger the culture and my ability to perform. My partner Ben [Raybould]
considers it his most critical job to cultivate and maintain a culture that
minimizes emotional noise and short-term performance pressures, to which I
must say he has done a fantastic job. We believe patience and discipline are
critically important to investment success. Taking emotion out of the equation,
or at least minimizing it as much as possible, is vitally important and difficult to
do if you have investors peering over your shoulder in real time, questioning
ideas. That’s like telling someone what’s wrong with their golf game in the
middle of their backswing — it’s the last thing you need when you’re trying to
concentrate and execute a shot.
MOI: We could conduct this entire interview simply by revisiting quotes from
your past letters, which are a tour de force. You recently didn’t hold back on
your view of certain types of institutional investors: “Many times these gate-
keepers of capital have expressed admiration for our results. Yet for them to
invest we would need to not only continue to find undervalued stocks, we’d

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 need to find more of them; additionally, we would need to identify overvalued
stocks – and short them – as well as find ideas across the globe in both large and
obscure markets. Such comments are flattering, yet we see nothing but wild-
eyed hubris attempting to outsmart people, more often, in more ways, and in
more markets, as opposed to sticking with what produced top-tier results in the
first place.” Clearly, the proliferation of investment vehicles whose partners’
interests are at odds with those of the ultimate owners of capital has resulted in
misallocation of capital. Do you see owners waking up to this inherent conflict
and demanding a more sensible approach to investment? Is it feasible for a fund
like yours to bypass the agents and go directly to the owners of capital?
Mecham: I think it’s possible to gain traction but I’m not optimistic about
change on a large scale as there are multiple factors at play. Bypassing the
agents is a laborious process that’s difficult for a two-man shop like ours. The
fees throughout the financial system are crazy and make no sense when thinking
about the industry as a whole. A lot of financial intermediaries and hedge funds
operate using a form of the “Veblen” principle — where status is attached to the
high cost and exclusivity of the product. The financial middlemen satisfy the
clients’ emotional needs more than the financial needs. The comfort of crowds is
strongly at play throughout the system. At the end of the day I think managers
are giving clients what they want — peace of mind and smoother returns, albeit
at the expense of long-term results.
“The financial middlemen MOI: Short-term thinking seems to be alive and well in the investment industry
satisfy the clients’ emotional despite overwhelming evidence that a longer-term perspective yields better
needs more than the financial results. You have alluded to the fact that good ol’ career risk may be the culprit:
needs. The comfort of crowds “Non-activity in the face of short-term underperformance is simply not
is strongly at play throughout tolerated, even though realistic assumptions (you can’t outsmart other smart
the system. At the end of the people all the time) and basic math (lower frictional costs) confirm its worth.
day I think managers are Most fund managers’ capital would not stick around long enough so they simply
giving clients what they want comply with more standard methods of operation in the spirit of keeping their
— peace of mind and jobs.” Incentives are one of the most powerful forces driving behavior, so it’s
smoother returns, albeit at little surprise investment managers have adjusted to the prevailing industry
the expense of long-term incentives. What could be done to better align career risk with investment risk?
results.” Mecham: I am a strong believer in the power of incentives. That being said, I’m
not sure I have a silver bullet on how to solve the problem. You need investors
to think and act like owners, rather than short-term renters, and to judge
performance over longer time frames. I remember reading a talk that Mark
Sellers gave at Harvard a few years back. He basically said good investors have
the right temperament by age 15, and there’s not much one can do to improve
later in life. So I don’t think arguing the merits of one’s philosophy is going to
gain a lot of traction — it seems people either get it or they don’t. If you could
somehow get investors to accept annual reporting (which is arguably too often),
or some type of soft or hard lock-up, that may help, but again, it’s a hard
problem to solve as you’re dealing with human nature to a large degree.
We are fanatical about partnering with compatible investors — those who
“get it” — and we still have soft lock-ups at Arlington Value Capital. The
sophisticated family offices (and others) often ask, “What’s your edge?” I firmly
believe it is our investor base — they act and think like owners rather than
traders, which enables us to wait for exceptional opportunities. Such an investor
base really adds value when you go through periods of distress and

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 underperformance; precisely the time when you need confidence and stability is
apt to be the time when investors are rushing for the exits and questioning the
approach. Our investor base is unique: despite above-average volatility we’ve
had minuscule withdrawals over the years. Part of the genius in the structure of
the Buffett partnerships (which has largely been maintained at Berkshire), is the
culture and environment Buffett created and insisted upon; Buffett wouldn’t
disclose positions and reported just once a year — he created an environment
where nobody was questioning how or when he swung the investment bat.
MOI: Let’s switch gears and discuss the investment philosophy behind your
track record. Help us understand the kind of investor you are, perhaps by
highlighting a couple of examples of companies you have invested in or decided
to pass up. What are the key criteria you employ when making an investment
decision?
Mecham: It’s really quite simple. I need to understand the business like an
owner. The firm needs to have staying power; I want to be confident about the
general nature of the business and industry landscape on a longer term basis. I’m
big on track records, and generally stay away from unproven companies with
short operating histories. I also believe a heavy dose of humility and intellectual
honesty is important when looking at potential ideas.
There’s a strong undercurrent constantly percolating to buy something —
“When looking at ideas, I it’s fun, exciting and feels like that’s what you’re getting paid for. This makes it
have a Richard Feynman easy to trick yourself into thinking you understand something well enough when
quote tattooed in the back of you don’t, especially if you are in the investment derby of producing quarterly
my brain: ‘Don’t fool and yearly returns! When looking at ideas, I have a Richard Feynman quote
yourself, and remember you tattooed in the back of my brain: “Don’t fool yourself, and remember you are
are the easiest person to the easiest person to fool.”
fool.’” Ultimately, what tends to cover all the bases is the mentality of buying the
business outright and retaining management. Critical to implementing this
approach is, again, having a compatible investor base. “Whose bread I eat his
song I sing”… An owner’s mentality forces you to think hard about the
important variables and makes you think long term, as opposed to in quarterly
increments. In fact, I think very little about quarterly earnings and more about
the barriers to entry, competitive landscape/threats, the ongoing capital needs
and overall economics, and most importantly, the durability of the business.
Over the years I’ve come to realize the importance of management, so we look
hard at the people running the business as well. And, obviously, the price needs
to make sense.
The criteria bar is set high; we really try to avoid mediocre situations where
restlessness causes you to relax investment standards in one area or another. We
also stress test the business under various economic scenarios and look to a
normalized earnings power. We passed up many seemingly attractive ideas over
the years as we would ask, “What happens under 7-10% unemployment (when
unemployment was in the 4-5% range) and 6-8% interest rates?” And we would
ask, “Is the business overly reliant on loose credit extension and frivolous
spending?” Many names didn’t hold up under these stress test scenarios, so we
passed. We bought AutoZone [AZO] a few years back as it held up under
various adverse macro scenarios, and in fact performed exceptionally well
throughout the Great Recession. I constantly try and guard against investing in

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 situations where the intrinsic value of the business is seriously impaired under
adverse macro conditions. We prefer cockroach-like businesses — very hardy
and almost impossible to kill!
MOI: You have said that “analysts tend to overweight what can be measured in
numerical form, even when the key variable(s) cannot easily be expressed in
neat, crisp numbers.” Can you give us an example of how this tendency
occasionally creates an attractive investment opportunity for the rest of us?
Mecham: Sure. In a generic form, I think there are many instances where a
company hits a speed bump and reports ugly “numbers,” yet the long-term
earnings power and franchise value remain intact. Oftentimes a key cog of value
is in a form that’s difficult to measure — brands, mindshare/loyal customers,
exclusive distribution rights, locations, management, etc. Sometimes it’s the
location of assets that can be hugely valuable. Waste Management [WM] and
USG [USG] both have assets that are uniquely located and almost impossible to
duplicate, which provides a low-cost advantage in certain geographies.
Reputation is valuable in business, though hard to measure in numerical
form. Reputation throughout the value chain can be a strong source of value and
competitive advantage. I think Berkshire Hathaway’s reputation is very valuable
in a variety of areas, most obviously in acquiring other companies.
The various cogs of value differ between companies, but many times the
“Oftentimes a key cog of key variable(s) are difficult to capture in a spreadsheet model and/or are not
value is in a form that’s given the weight they deserve.
difficult to measure…
Sometimes it’s the location of MOI: You wrote recently that your “appetite is paltry for risky investments,
almost regardless of potential reward. Theoretically this stance is illogical as
assets that can be hugely
‘pot odds’ can dictate taking a ‘flyer’ — where the potential payoff compensates
valuable. Waste Management
for the chance of loss — however these situations are difficult to handicap, and
and USG both have assets
can entice one to skew probabilities and payoffs.” You put your finger on an
that are uniquely located and
interesting phenomenon: Many investors systematically overestimate the
almost impossible to probability and magnitude of favorable outcomes. We recall the countless times
duplicate, which provides a we have read investment write-ups that peg the expected return at 50-100%, yet
low-cost advantage in certain virtually no investor manages to achieve even 20+% performance over any
geographies.” meaningful period of time. What kinds of situations do you consider too risky
or, more appropriately, too susceptible to the skewing of probabilities and
payoffs?
Mecham: I’m not sure I can categorize the situations… Any time you are
paying a price today that’s dependent on heroics tomorrow — fantastic growth
far into the future, favorable macro environment, R&D breakthroughs, patent
approval, synergies/restructurings, dramatic margin improvements, large payoff
from capex, etc. — you run the risk of inviting pesky over-optimism
(psychologists have shown overconfidence tends to infect most of us), which
can result in skewed probabilities and payoffs. We want to see a return today
and not base our thesis on optimistic projections about the future. Many early-
stage companies with short track records fall into the “too risky” category for us.
Investments based on projections that are disconnected from any historical
record make us leery. Investments dependent upon a continued frothy macro
environment (housing, loose credit) are prone to over-optimism as well — how
many housing-related/consumer credit companies were trading at 6x multiples
growing 15%+ inviting IV estimates 5x the current quote?

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 Many times I think it can be a situation where you just don’t understand the
business well enough and the bullish thesis is the nudge that sedates the
lingering risks you don’t fully grasp. It’s important to keep the litany of
subconscious biases in mind when investing. Charlie Munger talks about using a
two-track analysis when looking at ideas. I think that’s an extremely valuable
concept to implement when looking at investment opportunities. You have to
understand the nature and facts governing the business/idea and, equally
important, you need to understand the subconscious biases driving your decision
making — you need to understand the business, but you also need to understand
yourself!
MOI: How do you generate investment ideas?
Mecham: Mainly by reading a lot. I don’t have a scientific model to generate
ideas. I’m weary of most screens. The one screen I’ve done in the past was by
market cap, then I started alphabetically. Companies and industries that are out
of favor tend to attract my interest. Over the past 13+ years, I’ve built up a base
of companies that I understand well and would like to own at the right price. We
tend to stay within this small circle of companies, owning the same names
multiple times. It’s rare for us to buy a company we haven’t researched and
followed for a number of years — we like to stick to what we know.
“The average stock price That’s the beauty of the public markets: If you can be patient, there’s a good
fluctuates by roughly 80% chance the volatility of the marketplace will give you the chance to own
annually (when comparing companies on your watch list. The average stock price fluctuates by roughly
52-week high to 52-week 80% annually (when comparing 52-week high to 52-week low). Certainly, the
low). Certainly, the underlying value of a business doesn’t fluctuate that much on an annual basis, so
underlying value of a the public markets are a fantastic arena to buy businesses if you can sit still
business doesn’t fluctuate without growing tired of sitting still.
that much on an annual
MOI: You have stated that your “old fashioned style embraces humble
basis, so the public markets skepticism and is wary of most modern risk management tools and ideas.” Give
are a fantastic arena to buy us a glimpse into how you construct and manage your portfolio — and how you
businesses if you can sit still protect it from the kind of upheaval the markets experienced in late 2008 and
without growing tired of early 2009.
sitting still.”
Mecham: There’s no substitute for diligence and critical thinking. It’s ingrained
in my DNA to think about the downside before any potential upside. We try and
stick with companies we understand, where we have a high degree of confidence
in the staying power of the firm. We spend considerable effort thinking critically
about competitive threats (Porter’s five forces, etc). We really stress long-term
staying power and management teams with proven track records that are focused
on building long-term value. Then we always “stress test” the thesis against
difficult economic environments. As I said earlier, we try and guard against
investing in businesses reliant on some type of macro tailwind.
If you have the above, combined with the freedom to take the long view,
managing the portfolio is based more on intellectual honesty and common sense
rather than any sophisticated “tools,” “models,” or “formulas.” If the financial
crisis taught nothing else, it showed how elegant financial models that calculate
risk to decimal point precision act like a sedative towards critical thinking and
even common sense — “risk models” were like the bell that told the brain it was
time for recess! I also think risk management by groups can have similar effects.
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 Being diligent, humble and thinking independently are key ingredients to solid
risk management.
MOI: What is the single biggest mistake that keeps investors from reaching
their goals?
Mecham: Patience, discipline and intellectual honesty are the main factors in
my opinion. Most investors are their own worst enemies — buying and selling
too often, ignoring the boundaries of their mental horsepower. I think if
investors adopted an ethos of not fooling themselves, and focused on reducing
unforced errors as opposed to hitting the next home run, returns would improve
dramatically. This is where the individual investor has a huge advantage over
“Most investors are their own
the professional; most fund managers don’t have the leeway to patiently wait for
worst enemies — buying and
the exceptional opportunity.
selling too often, ignoring the
boundaries of their mental MOI: What books have you read in recent years that have stood out as valuable
horsepower.” additions to your investment library?
Mecham: I enjoy all the behavior psychology stuff and would recommend
Predictably Irrational [by Dan Ariely], Nudge [by Richard Thaler], How We
Decide [by Jonah Lehrer], and Think Twice [by Michael Mauboussin].
The Big Short [by Michael Lewis] is a good book and a very entertaining
read. Roger Lowenstein’s new book, The End of Wall Street, is very good as
well. I’d also recommend The Relentless Revolution [by Oldham Appleby]. I
like reading history of all sorts and think it’s beneficial to investing.
MOI: Allan, thank you very much for your time.

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