The 400% Man

Published: Feb 13, 2012 12:03 p.m. ET

Last Updated: Feb 21, 2012 8:44 a.m. ET

How a college dropout at a tiny Utah fund beat Wall Street, and why most managers
are scared to copy him.

By

BRETTARENDS

COLUMNIST
On a fall day in 2010, half a dozen wealthy investors and portfolio managers converged on an office in
midtown Manhattan. These were serious Wall Street moneymen; in aggregate, they handled more than a
billion dollars. They had access to the most exclusive hedge funds and investment partnerships and often
rubbed shoulders with the elite of New York, Greenwich and Palm Beach.

But on this day, they had turned out to meet an unknown college dropout from Utah -- and to find out how
he was knocking them all into a cocked hat.

The unknown, Allan Mecham, had been posting mind-bogglingly high returns for a decade at a tiny private-
investment fund called Arlington Value Management, and the Wall Streeters were considering jumping on
board. For nearly two hours, they peppered him with questions. Where did he get his business
background? I read a lot, he replied. Did he have an MBA? No. I dropped out of college. Did he have a
clever computer model or algorithm? No, he replied. I don't use spreadsheets much. Could the group look
at some of his investment analyses? I don't have any of those either, he said. It's all in my head. The
investors were baffled. Well, could he at least tell them where he thought the stock market was headed? "I
don't know," Mecham replied.

When the meeting broke up, "most people left the room mystified," says Brendan O'Brien, a New York City
money manager who was there. "They were expecting to see this very sharp-dressed, fast-talking guy.
They were saying, I don't get it, I don't understand why he wouldn't have a view on the market, because
money managers get paid to have a view on the market." Mecham has faced this kind of befuddlement
before -- which is one reason he meets only rarely with potential investors. It's tough to sell his product to
an industry that's used to something very different. After all, according to their rules, he shouldn't even be in
the business to begin with.

Over a 12-year stretch, through the end of 2011, Mecham, now a mere 34 years old, has earned an
astounding cumulative return of more than 400 percent by investing in the stock of U.S. companies -- many
of them larger ones like Philip Morris, AutoZone and PepsiCo. That investment performance leaves the
stock market indexes and most mutual funds trailing far in the dust. Of the thousands of mutual funds in
America, only a smattering of stock-oriented funds have done better, according to Lipper. Arlington, which
is structured like a hedge fund, has put most firms in that category deep in the shade as well. It even
managed to turn a profit during the crash of 2008, when Standard & Poor's 500-stock index fell nearly 40
percent. And Mecham has done this mostly while sitting in an armchair, in an office above a taco shop, in
downtown Salt Lake City.

Mecham doesn't look, talk or act like a typical Wall Street manager. He's soft-spoken. He doesn't use
jargon. He dresses like he works in a bookshop, with a patterned shirt and a plain tie. And the story of his
success, arguably, says a lot about the flaws of the fund-management industry. By his own account, and
those of other investors who have vetted his fund, Mecham has no secret sauce or amazing algorithm;
what's extraordinary about this young man is how ordinary he is. But his investment approach relies on a
handful of common-sense tactics -- focusing on just a few stocks, for example, and avoiding or ignoring
short-term statistical analysis -- that big money-management firms either can't use or are reluctant to try.
Skeptics and admirers alike agree that Mecham's approach involves a higher-than-usual potential for hefty
losses. Russ Kinnel, director of fund research at Morningstar, says most fund customers would be unlikely
to take that chance. "Pension funds, consultants, investors in general are quite benchmark-centric," Kinnel
notes; they get uncomfortable when their money managers deviate.

But that notwithstanding, it would be a bit of a stretch to characterize Mecham as a rebel -- this is a man,
after all, for whom one of the highlights of the past year was a trip to Omaha. (He took his girlfriend to
Warren Buffett's annual investment conference.) As does virtually every other manager in the business,
Mecham says he would like to raise more capital to invest -- his firm is small, with $80 million under
management. But for now, the handful of pros who have jumped on his bandwagon are happy to have the
fund remain undiscovered. It's clear that several think they're onto something special.

After the awkward New York meeting, O'Brien, who runs Gold Coast Wealth Management, was sufficiently
intrigued to do more digging -- and after spending months talking with Mecham and checking his results, he
got on board, investing more than $1 million with the Utah unknown. "To use a sports analogy," O'Brien
says, finding Mecham was like "one of the rare few times when a star free agent becomes available in the
beginning of his prime."

It's sensible these days for investors to approach the story of any stock market wunderkind with caution --
all the more so in the private-investment world, where money managers operate without the checks,
balances and scrutiny that large mutual funds endure. Many such funds don't have to register with the
Securities and Exchange Commission, especially if they're small and if big research companies like
Morningstar don't track their performance. With the minimum stakes in such funds often very high -- at
Arlington Value, the ante is typically at least $1 million -- investors have an even bigger incentive to do their
own due diligence. (O'Brien, for instance, says he spoke to Arlington's auditors to confirm the investment
figures, then did a background check on the auditors.) Factor in that the history of Wall Street is littered with
the careers of investment hotshots who flamed out, and betting on a manager ultimately becomes a leap of
faith.

Rule-Breaker's Rules
Money pros who know him say none of Allan Mecham's investing tactics are astonishingly difficult
-- but for various reasons, most investors don't use them.
Ignore the economy. Where is the economy going next quarter? Where is the S&P headed? Mecham
says he ignores those issues; instead, he looks for stable, defensive businesses that can thrive whenever
bad times come.
Don't diversify. Most mutual funds own dozens or even hundreds of stocks (regulations usually require
them to own at least 15). But to outperform with a big portfolio, a manager has to outsmart the market
simultaneously on a raft of securities. Smaller funds and private-investment funds, which are not under the
same requirements, can rely on just six or eight stocks.
Don't sweat the spreadsheets. Many Wall Street analysts build elaborate financial analyses to calculate a
company's earnings growth and other patterns. But some say it's more productive to use that time trying to
understand a company and its industry -- the management, the competition, the customers and so on.
Think decades, not quarters. Shareholders and managers tend to focus on companies' announcements
of quarterly or annual earnings, and whether they beat or miss analysts' estimates. But some managers --
including one Warren Buffett -- say it's more useful to try to figure out where a company will be in a decade
or more.
Don't just do something. Stand there! One of the toughest things for investors to do is to sit still and do
nothing -- especially when nervous clients demand that they respond to short-term fluctuations in the
market. But most of the time, say a few contrarians, inactivity is the right longer-term move. It's about
"keeping emotions from corroding the decision process," says Mecham.

In Mecham's case, that faith resides in someone whose background is highly unusual for this industry.
Mecham attended a community college and the University of Utah for two years -- but soon after starting an
investment club, he says, he found his schoolwork boring by comparison. He would read books about
investing and business. "I was 19," he recalls. "I was staying up till 3:30 a.m. devouring this stuff." Salt Lake
City is a cohesive town where people know each other, and a classmate knew people at Wasatch Advisors,
a local mutual fund company. Mecham landed a job there and eventually decided not to go back to school,
choosing to stay on with the firm instead.

Mecham's Wasatch bosses say they remember him as a good, but not unusually good, employee who
made one memorably successful stock pick, recommending that the firm buy a health-services company
that did quite well. Still, it was only about a year before Mecham decided he could run money himself. He
raised seed capital -- less than $200,000, he says -- from a handful of local investors led by Robert
Raybould, a former real estate developer who is the father of Mecham's childhood friend Ben Raybould.
And in 1999, Mecham launched his fund -- at the well-seasoned age of 22.

Since then, word of mouth has drawn more assets to Arlington, with Ben Raybould acting as Mecham's
partner and the fund's main salesperson; regulatory filings show that the firm has about 120 investors, with
more than 75 percent of them identified as "high-net-worth individuals." According to Raybould, of the $80
million in the fund, about half is investors' principal, and the rest, profit. But Mecham says his habits today
are roughly the same as they were back when he had $200,000 to invest. He sits in that armchair by the
window, carefully reading company filings and other records from atop a giant pile of material that he prints
out each day. (Mecham prefers to read only on paper, not online -- old school.)

His investment approach will be familiar to anyone who has been even a casual follower of Buffett.
Mecham looks for businesses with great long-term prospects, great management, strong cash flow and big
defensive "moats," or barriers to entry for potential competitors. And he stresses the importance of sitting
still and doing nothing. "Activity is the enemy of returns," says Mecham. "If I find two new ideas a year,
that's phenomenal." Two ideas a year adds up to a pretty small portfolio -- Mecham typically owns between
six and 12 stocks. (That's one thing that sets him apart from mutual fund managers; because of industry
regulations on diversification, traditional funds typically have to have at least 15 holdings.)

The names of the stocks from which he has made his money over the years tell a lot of the story. They're
not exactly glamorous or sexy businesses. (Mecham has never owned Apple. "Our portfolio is not one to
get you excited," he jokes.) Some are well known, such as PepsiCo, fast-food giant Wendy's, health care
firm Wyeth, consumer-products company 3M and Buffett's Berkshire Hathaway. Others are less so, like
Watsco, a $2 billion company that's the U.S.'s largest distributor of air-conditioning equipment and supplies.
Mecham says he loves the company's management and business model, but the choice was an industry
pick as well -- in much of the country, he notes, when your air-conditioning system breaks down, getting it
fixed "isn't a want, it's a need." Another little-known favorite, Heico, makes components for jet engines.
Mecham's argument for the stock is brief, straightforward and Buffett-like: There are huge barriers to entry,
he says, the replacement cycle is driven by regulation, and customers are not aggressive about demanding
lower prices.

Indeed, Mecham can tell a good story like this about any stock he owns. But he writes these stories by
himself, based on his own research -- unlike most fund managers, he generally doesn't meet company
management. That's partly a function of his fund being small; he's not in a position to buy huge stakes that
can make or break a company. But Mecham doesn't like meeting management even where it's possible.
"Management is usually likable," he says. "They'll never tell you things are going to hell in a basket."
Indeed, Arlington's worst patch came from getting too close to a company: local Internet retailer
Overstock.com. Ben and Robert Raybould take the blame for persuading Mecham to invest in it and then
persuading him to hang on when the stock cratered in 2005. Mecham called the decision "management by
committee." The fund dropped by a third that year, while the market rose. Mecham argued with his backer,
and in the aftermath, Raybould agreed to leave Mecham alone. (Overstock.com President Jonathan
Johnson declined to comment about the stock price, but says he knows and likes Mecham.)

It was a very different story in 2008, Wall Street's annus horribilis, the year of Bear Stearns and Lehman
Brothers. The financial meltdown was an event that blew up almost every smart money manager from
Boston to Beijing. The S&P crashed 37 percent. Most actively managed stock funds did worse, and those
that cut their losses often did so by fleeing stocks for cash. Arlington? It doubled down, loading up on
stocks that would do well in a downturn.

An Elite Club
 A 400% gain, which turns a $100,000 stake into a $500,000 jackpot, is a hall-of-fame feat for money
managers. Below, some of the few who have pulled it off.
Warren Buffett
 Holding company: Berkshire Hathaway
 Market cap: $191 billion
 The 400% run: 80 Months. july 1989-February 1996
 The Oracle of Omaha has punched his 400 percent membership card more than once. This run,
capped with a 57 percent gain in 1995 alone, got a boost from Buffett's famous investment in Coca-Cola,
which he bought in 1988. Berkshire's recent returns haven't been as dramatic, but the company largely
managed to avoid stumbles that have tripped up other well-known managers over the past decade.
Kenneth Smith (with others)
 Fund: Munder Growth Opportunities (MNNAX)
 Assets: $460 million
 The 400% run: 17 Months. october 1998-February 2000
 This fund, formerly known as Munder NetNet, epitomized the industry's embrace of the dot-com
era. After it nearly tripled investors' money in 1999, its assets ballooned to more than $11 billion…and
then the bubble burst. In the three years that followed, the fund lost 85 percent of its value. Over the past
decade, though, Growth Opportunities, which has shuffled its management team, has beaten the market
handily.
Bill Miller
 Fund: Legg Mason Capital Management Value Trust (LMVTX)
 Assets: $2.6 billion
 The 400% run: 85 months. April 1994-April 2001
 Miller, who quintupled investors' money in just seven years, attributes gains during this period to
savvy tech calls: buying names like AOL and Dell early, then selling ahead of the tech crash. But he will
be stepping down from the fund in April on a less triumphant note. After a series of big bets on banks
went sour during the financial crisis, he has trailed the S&P 500 in five of the past six years.
Sam Stewart, Robert Gardiner, Daniel Chace
 Fund: Wasatch Micro Cap (WMICX)
 Assets: $275 million
 The 400% run: 90 months. november 1999-April 2007
 This fund managed a four-bagger in less than eight years by finding bargains among companies
valued below $1 billion. The bad news: Small firms "struggled mightily" when financing dried up during
the recession, according to Wasatch founder Sam Stewart. Micro Cap lost roughly half its value in 2008,
but investors who stuck with it have beaten the S&P 500 by three percentage points a year, on average,
over the past decade.
-- By Ian Salisbury

One was AutoZone, the chain that made more than $8 billion in revenue in 2011 selling car parts directly to
consumers. Mecham had been building a stake since 2005, and he was convinced it was a "countercyclical
stock" that would thrive even in a poor economy -- when consumers are hurting, he explains, they keep
their old cars longer and fix them themselves. AutoZone stock gained more than 16 percent in 2008; since
then, it has more than doubled. Mecham also zeroed in on Canadian insurance company Fairfax Financial
Holdings. Wall Street had dumped the stock overboard in the panic, but Mecham had actually read the
company's filings -- and he knew most of its assets were in Treasury bills and other ultrasafe positions.
Arlington added to its already large position, and Fairfax rose 12 percent in the last two months of the year.
The result: Arlington as a whole was up a remarkable 11 percent in 2008 and another 59 percent in 2009.
No public equity mutual fund in America came close.

So why don't other mutual fund managers think and act like this? Bonnie Sewell, a wealth manager at
American Capital Planning who oversees money for high-net-worth clients across the country, says
concentrated portfolios can prove incredibly volatile. She says she wouldn't bet more than about 10 percent
of a portfolio on an individual manager like Mecham, no matter how good, because of the inevitable risk --
or even likelihood -- that what goes up will come down. Regardless of their strategy, even managers with
terrific track records can get cocky or complacent, or they can just make mistakes.

As investing sages like Buffett often point out, people on Wall Street are also subject to enormous career
pressure to conform. If they took a big bet, like Mecham's on Fairfax, and it didn't work out, clients would
bolt, and they typically would be fired or pushed out. But no one would get fired for missing an opportunity
like that. The same goes for how managers react to short-term news in the market. Mecham says one of
his big advantages over Wall Street managers is that he is free to ignore "noise" -- like the quarterly
obsession over short-term earnings, which often drive stock prices sharply up and down as investors
stampede in herd behavior. The first question he asks of any investment, he says, is where it will be in 10
years or more: "You have to have a high degree of confidence in the cash flows over the next decade."
Mecham says that in contrast, the typical mutual fund manager is like someone who's hired to run a
marathon -- only to have his clients announce that they're going to compare his time every 100 meters with
that of an Olympic sprinter running a dash. "It's a myopic process," he says, with resignation.

Where does Arlington head next? Mecham says he won't compromise his strategy to play the Wall Street
game. That leaves Ben Raybould battling to market a fund, and a manager, that many other money
managers can't even understand. Mecham is bemused that so many people expect him to hold a broad
basket of stocks and follow a benchmark, such as the S&P 500. "It's laughable to think that in this
competitive world, you're going to find brilliant ideas every day," he says. "The world's just not set up that
way."