Episode #185: Ben Claremon, Cove Street, “Value Investing Will Always Have A Place”
Guest: Ben Claremon joined Cove Street in 2011 as a research analyst. He also serves as Co-Portfolio Manager for the Classic Value | Small Cap Plus strategy. Previously he worked as an equity analyst on both the long and the short side for hedge funds Blue Ram Capital and Right Wall Capital in New York. Prior to that, he spent four years with a family commercial real estate finance and management business. He was also the proprietor of the value investing blog, The Inoculated Investor.
Date Recorded: 7/31/19
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Summary: In episode 185 we welcome our guest, Ben Claremon. Ben and Meb start the conversation with some background on the blog Ben started in school, The Inoculated Investor. From there, the pair move on to discuss Cove Street and the investment process.
Ben gets into investing, and what value investing means to Cove Street Capital, bifurcated between Warren Buffett style investing and Benjamin Graham style investing. Next, Ben discusses the investment and portfolio construction process he and the team undergo at Cove Street, including sell discipline applied to fund positions.
Ben and Meb get into the outlook for the investment landscape, covering Value investing to opportunities in China, as well as the auto industry. He also discusses some things to avoid.
Ben then gets into the importance of proxy statements, and the role corporate governance plays in the investment process.
As the conversation winds down, Meb and Ben get into the bogeyman of buybacks and talk about the idea that the focus should instead be on the short-term nature of the earnings cycle.
All this and more in episode 185, including Ben’s most memorable investment.
Links from the Episode:
- 0:50 – Welcome our guest, Ben Claremon. author of the old blog The Inoculated Investor and what made him start it and abandon it
- 3:21 – The Intelligent Investor: The Definitive Book on Value Investing. A Book of Practical Counsel (Graham)
- 5:40 – Importance of scarcity and collectibles
- 6:51 – The Meb Faber Show – Episode #48: “The Rare Coin Market Can Go Up Dramatically, Quickly”
- 7:55 – The Meb Faber Show – Episode #166: Radio Show: Greece and Russia Are Having Monster Years…Geographic Diversification…and Meb’s 401(k)
- 8:22 – Early start to Ben’s career
- 10:06 – Cove Street Capital
- 11:48 – How Cove Street defines value investing
- 16:30 – The investment process
- 23:55 – Sell discipline
- 28:00 – How the investing world looks today
- 29:32 – Cove Street Capital letter
- 33:35 – Types of investments to avoid
- 35:04 – How having a mutual fund changes the Cove Street business
- 38:11 – The way Cove Street values people
- 39:35 – The proxy statement and its value
- 41:54 – The downside of judging companies quarterly
- 44:53 – Companies willingness to take advice
- 49:26 – Burying the news on Friday nights
- 49:40 – The Meb Faber Show – Episode #94: “There Are Some Companies That We Know Are Sort of Bad Eggs”
- 51:14 – Back to the value of proxy statements
- 55:48 – Best resources
- 56:07 – LinkedIn
- 56:38 – Expert networks
- 58:18 – Interviewing people and their references
- 1:01:07 – The power of knowing the competition
- 1:02:04 – How Ben’s time is used in the investment research process
- 1:04:35 – The Outsiders: Eight Unconventional CEOs and Their Radically Rational Blueprint for Success (Thorndike)
- 1:05:12 – Books and resources that were a big influence to him
- 1:10:41 – Most memorable investment
- 1:18:00 – Connecting with Ben: Cove Street Capital Blog
Transcript of Episode 185:
Welcome Message: Welcome to “The Meb Faber Show” where the focus is on helping you grow and preserve your wealth. Join us as we discuss the craft of investing and uncover new and profitable ideas all to help you grow wealthier and wiser. Better investing starts here.
Disclaimer: Meb Faber is the co-founder and chief investment officer at Cambria Investment Management. Due to industry regulations, he will not discuss any of Cambria’s funds on this podcast. All opinions expressed by podcast participants are solely their own opinions and do not reflect the opinion of Cambria Investment Management or its affiliates. For more information, visit cambriainvestments.com.
Meb: Hey, podcast listeners, I hope you’re enjoying your summertime. We have a great show for you today. We got a stock picker in the house. He’s a principal portfolio manager at Cove Street Capital. He used to be one of our neighbours, still close by. He joined back in 2011. For that, worked as analyst on both long and short side, hedge funds, Blue Ram, Right Wall, up in that city, New York. Also, going back to the early days of investment blogging, some of the old school listeners may remember “The Inoculated Investor.” Welcome to the show, Ben Claremon.
Ben: Thanks for having me.
Meb: Ben, what’s up, man? It’s good to see you, it’s been a while. How are things? Are you enjoying a full summertime in L.A.?
Ben: I would say relative to being in France where it’s 108 degrees or even in, you know, downtown L.A. where it’s much hotter, I think being in the South Bay works pretty well for me.
Meb: My brother, I think, is leaving today to go to France with his three children of the ages 5 to like 12 solo. And I said, “You are crazy, dude. You are crazy.”
Ben: That’s a lot of work.
Meb: I have a hard enough time. I look exhausted just from one two-year-old. Well, look, some of the podcast listeners may know your name. They may know your blog and I’m really sad you at some point just said, “No mas.”
Ben: The truth of the matter is the blog was a means to an end in the sense that I always want to be a securities analyst. I was in business school when I started it. For those of you who may not remember it, I was the crazy guy who just tried to take every word of what Buffett and Munger said at the annual meeting, the Berkshire annual meeting, I tried to take down every word and it kinda spiralled into a really interesting opportunity to meet people and to get my name out there. And it was a really fun way to kinda stay in the game while I was in business school but the goal was always to be kind of an analyst.
Meb: You know, it’s funny because that time period in markets and in blogging, I mean I beat you by a couple of years. I think I had started writing in ’06, but really that was kinda like the second wave. First wave would have been like Ritholtz back in…I mean he’s old, back in late ’90s. Love you, Barry. But then, you know, kinda the second wave now it’s everything everywhere, but the name is a little bit of a riff on Buffett, too, for those that are Buffett fans.
Ben: There is a quote, I think it’s actually attributed to Klarman, but I think it might have been Seth Klarman quoting Buffett about how investing is like an inoculation, and you either take it or you don’t. And I think I read Ben Graham’s book when I was working in the real estate industry and I said, “This is me.” I was a value investor before I even know what value investing was. It was in my bones and it was in my blood, and so I decided to try to make a career of it. And so that inoculation really took for me and it’s such a cliché to say a book changed your life, but to some degree, just the exposure to what value investing was really changed my career trajectory.
Meb: So, the real inoculation didn’t happen until you were in your 20s, like the full Buffett. I think my inoculation was being like an extreme gambler my entire life. I had the genetic, not speculation bug, which is why I’m a quant, to keep myself from blowing up all my own money. I think that’s what I was inoculated with. But we have some old postcards I had sent my father talking about investing ideas from summer camp once, which sounds like the bougiest thing ever I can think of but funny to look back on. So, I was inoculated with something, I don’t know what. It may have been, it’s not pink eye. What’s the one that everyone gets where it’s super itchy? Inoculated with chickenpox and stock picking. All right.
Ben: You wanna know a really funny story which I don’t think I’ve ever told anybody?
Ben: So, I was a big baseball card collector back in the day and this is before I understood exactly how to value things and what a bubble could look like. But me and my friend in high school, we used to go to the shows and actually be on the dealer side. So, I was from the very beginning kind of like the guy who was like, “I see what this is worth, I wanna buy it for less and then I wanna go sell it for more.” And so, I mean from the very beginning, there is an entrepreneurial, value, investing kinda spirit.
Meb: I love it. Well, I’ve got the other side, which was learning that markets were rigged because my brother would open up all the baseball card packs. I was young enough to really not know who was good other than like Darryl Strawberry. And he would essentially go through my cards to help me and then just take all the good cards. So, it’s like a high frequency trader today, scalping off your profits. But suspiciously enough, he ended up with a good collection. Although, a great funny example, this podcast had already taken a turn, the cards in our collection that are worth by far the most are actually like the ones my mom bought. No interest in cards or collecting but when buying us stuff, she’s like, “Well, you know, I like basketball so I’m gonna buy some basketball cards to just be a cool mom and hang out and something to talk about with you guys.”
No one was collecting basketball cards. She’s got like the Jordan rookies, you know, just like the same thing with comic books. So, I was a comic book guy, too, and I have these boxes and boxes and boxes of comic books from growing up because we just go on a bunch of road trips. They just give me a handful of comic books, say, “Here you go.” Just like, “Shut up, kid.” That was the old school iPad, it was comic books. And, of course, I have this huge collection and sure enough she’s like, “I think we have some comic books in the attic.” And they’re like old Western something. No one’s even heard of them but because they’re so old, again, there’s like five of them and they’re worth more than the entire collection as well. So, there’s something to be said for luck, too, but baseball cards, Stadium Club, Upper Deck, I think that kinda was when it hits, that was like the equivalent for us of the late ’90s internet boom, maybe crypto today.
Ben: But I think it’s a really good example that translates well into financial markets in the sense that baseball cards were these scarce things. And if you look at the Mickey Mantles and Joe DiMaggios and the Hank Aaron rookies and things like that, there weren’t that many out there. And the proliferation of supply basically destroyed the market. Everyone came out with not even just…even back in the ’80s, there was Donruss and Leaf and there were like five different things that came out. And then by the late ’90s, everyone had 20 different collections and sub-collections. And so, if you look at just the supply and demand, that’s what really destroyed the market.
Meb: We had one of our first guest was a collector trader who helped invent the grading system for baseball cards, PCGS or whatever it’s called. We asked him in the podcast, I said, “Van, why isn’t this all computer automated? Why don’t you just have a computer to do this, like get rid of human judgment?” He said, “We actually built one.” I think he said, “We spent like millions of dollars doing it but people still wanted the human element for whatever reason.” I think that may change eventually because there was just like a big scandal recently with someone doing fake grading and something that just came out. Anyway, but interesting ideas nonetheless. But this whole concept of securitizing cards, we say this one is worth $7, this one is worth $10, assuming there’s trust in the system, makes it easier to trade but who knows? I’ll go dig up my mom’s and my cards to see what they’re worth when I go back to Colorado. Let’s talk about old-school real investing. Do you still have any cards, by the way?
Ben: I do and I’m a little afraid to look at them because I bet they’ve depreciated significantly in value since they were purchased. I don’t spend a lot of time on that these days.
Meb: We had a funny radio show where we talk about…I’d never heard the story but Wally Joyner and Dave Bucci, Bocci, was his name had worked with Upper Deck and I think Joyner got paid like 17 grand but the other guy took payment in equity and it was worth like $15 million eventually or something. I think that’s the story, I can’t…massacring all these stories. But generally, conceptually, it’s the same. So, we’re talking about this whole concept of get paid in equity rather than salary if you can help it. All right. Let’s talk about investing. All right. So, you’re in school, business school, started writing, real estate, then started doing some old-school security analysis?
Ben: Yes. So, my family is in the commercial real estate business and, as I said, I kinda got inoculated in value investing. Decided to try to get a job on the buy side. I was lucky enough to be able to get my first job with almost no experience other than being self-taught, which is not something easy to do. And I don’t know with how easy that is to replicate but I was lucky enough to get a job on the buy side. Timing was terrible, right before the financial crisis, and I learned a lot my first few years but I really felt like I needed more of a grounding in at least the fundamentals of investing, and especially accounting. So, I went back to business school and that’s when I started the blog, and I was lucky enough…and this is another amazing story in my life is that a guy who I didn’t even know knew my blog and knew that my boss, the current founder of Cove Street, was looking for an analyst and recommended me. There was a talk about just serendipity on my part, someone who I’d never even met and I’ve thanked him a lot since that moment. But this was 2011 and really hard to get a job at that point and so I feel very fortunate to have been in Cove Street for eight years now.
Meb: We tell people all the time though. I mean, obviously, we’ve been doing it for a long time content and various means but we get so many inbounds, I’m sure you do too, on young people looking for jobs and how to go about it and what to do. Regardless of the fear of it and getting yourself out there, just creating something like the blog even if it just acts like a diary that forces you to express some ideas, do some research and then put it out in public. And there’s a million different ways to do this now, there’s Value Investors Club, Sum Zero, more formalized ways to sort of works through that. Its certainly better than probably doing nothing in 2019 as far as looking for a position. So, let’s talk about Cove Street, what are you guys doing? I know the answer to that but to our listeners.
Ben: So, Cove Street founded in 2011, Chief Investment Officer is Jeff Bronchick and he’s a 30-plus-year veteran in the industry. We’re long-only value investors, the dying breed. We work for a flat fee, we’re not the 2 and 20 guys, so everyone else has a great business model and we’re the guys with under the fee pressure all the time. But the greatest thing about Cove Street, I think, is culture. We have a 12-person team, 9 of 12 of us are partners and 5 on the investment team, which means that we make partners for people who aren’t on our investment team, which I think is just, it speaks to how important the whole system is in having institutional quality back office and great traders. It’s really part and parcel to being a good investment manager because institutional clients are not just looking for stock pickers, they’re looking for an institution that can survive, take a punch if something happens or if you lose a client, it’s fine.
And so, we’re a little different. We wear shorts on Fridays, closed-toe shoes and collared shirts is the dress code. We have graffiti on the wall. We invite anybody to come to our office and check it out. It’s a serious organization but with a casual feel because we wanna have freedom for ideas and freedom to express yourself, not close the walls and, you know, everyone having to wear suits every day.
Meb: The opposite of our earlier comment about getting paid in equity is if, of course, you’re the business. Hopefully, you didn’t pay for the graffiti like Facebook did in equity or Facebook…What was that graffiti artist eventually, like $300 million or something? It was originally a 60 grand bill where he did the garage door graffiti. That thing is worth $300 million or something. Anyway, all right. So, when you say…there’s two things. One, you say that long-only, hey, that’s a great place to be the last 10 years. But then you tack on the other word value, which, for many people, has been a massive, massive headwind over the past 10 years. Talk to us a little bit about what value means to you guys because to a lot of different people, it means totally different things.
Ben: Yeah. So, we think of value in two ways, I would say, and then we bifurcate our philosophy and strategy to some degree based on this two ideas of value. And so, one is called the Buffett value, and so this would typical Warren Buffett stock would be a high return on investing capital business, good management, something that you could buy for a reasonable price. Not a great price but a reasonable price and you benefit from the compounding over time. And on the other hand, you have a Graham value so that’s more of a tribute to Ben Graham. Ben Graham was a net-net investor, he was a balance sheet investor. He was willing to invest in mediocre businesses that were very cheap. And so, we look at those businesses and hope for a really large margin of safety. So, the Buffett is a good business at a reasonable price. The Grahams are a mediocre business to a decent business at a great price.
And our whole process is designed to try to figure out, what are you investing in? Is this a Buffett or is this a Graham? Because what that does, buying a stock is really easy but the sell discipline is really, really important. I think to be able to compound capital for the long run, you have to be very disciplined in how you sell securities. And so, the way it works for us is if it’s a Buffett and it gets near fair value, you’re more likely to hold it because you’re benefiting from the compounding, time is your friend. With the Graham, when it gets to fair value, we’re much more likely to sell it because for whatever reason, whether it’s customer concentration, or cyclicality, or some kind of cyclical decline in one of their businesses, time is not your friend. And so, once that…
Meb: Because many times it’s not a great business necessarily.
Ben: Yes. So, once that margin of safety has collapsed and you have realized the value, you’re more likely to sell. And so, I think we have a pretty eclectic view of what value is and the portfolio, our small cap strategy, is a mix of Buffett and Grahams. Now, I need to add one little addendum to that. And so, the strategy that I co-manage with our founder is our small cap plus strategy. It’s called small cap plus because we taught SMID was a bad word to some people. It’s basically our small cap strategy is $3 billion and under market companies and our SMID strategy, small cap plus, is a billion to $12 billion, so it’s slightly larger companies. And it’s a more Buffetty strategy.
Meb: How far down the mar-cap spectrum you go?
Ben: In terms of the…
Meb: What’s the smallest thing you buy?
Ben: We have some small things and small cap, they weren’t always that small but they’ve gotten smaller overtime. But yeah, I mean I think our core is $100 million to $3 billion in small cap and then a billion to $12 billion in small cap plus. So, the strategy that I co-manage is more Buffetty. I think it reflects my own transition as an investor. As I said, as I started off talking about, I read “The Intelligent Investor,” loved Ben Graham’s philosophy and said, “This is what I want to do for a living.” And after doing this for a number of years and having been trapped in businesses that weren’t getting more valuable every day, that didn’t have great management, that had certain issues whether they didn’t have any diversity of revenues or they had single customer risk or something like that, I just started to feel like value is important, of course, but the business and the people are what are really important, and that’s how you compound. You find great businesses that are run by great people and that’s how they compound over time. So, I become much more comfortable paying up for better businesses versus kind of bottom fishing for really cheap securities.
Meb: I think for just mental health reasons, it’s…easier is the wrong word but it feels slightly saner, the Buffett, because once you find a good company it’s like a flywheel where if it starts hitting on all cylinders, you could foresee owning it for years, decade-plus. The Graham stuff seems there often could be a lot more hair on it or warts, or it’s like being a short seller. It’s like you know it’s gonna be hard, you know you’re gonna be fighting people, you know it’s not…it just feels like it’s a lot more work. But anyway, both are certainly good fits.
And probably, I imagine, I don’t know if you tease it out or not, that there’s a fair amount of diversification benefits, maybe two, on where we end up fishing between the Graham and Buffett ideas. Whether they may or may not be exposed to the same sorta economic cycle or macro factors. I don’t know if when you put all the cookies into the…all the ingredients into the cookie batter if it matters but walk us…and we’ll kinda talk about this as we go, but walk us through the whole investment process. How do you guys find your ideas all the way to doing the research and then kicking them out one day, hopefully 100 bags later.
Ben: Yeah, happy to do that. So, let me just start with portfolio construction because that will frame the process a little bit. So, we run concentrated portfolios, our general time rise is three to five years. Ideally, we’d own these things forever and I think this is a buy and hold strategy for sure. And we start with a screening process that is trying to find good combinations of business, value, and people, those are our three pillars. And so, where do our ideas come from? I would like to say it’s pretty eclectic. So, we do run screens, we run cap, like you, populated screens that run every weekend. We come in on Monday morning and we discuss what’s on those screens. We also take a fair number of management meetings, which it wasn’t necessarily intentional but being located about eight minutes from LAX gives you the, “Hey, management team’s in town, they don’t have anything to do at 4:00, come to Cove Street” meeting, which is always really interesting.
And then we have Jeff Bronchick, our founder, has been in the business for 30 plus years, I mean the institutional knowledge there combined with the rest of the team is very deep. And then I think another really interesting way that we find companies is we start researching company X and we do the work. We understand the industry, we understand the people, and we kinda get a sense like, “No, no, this is not the right one. Their competitor is a good one.” And so, you use your research on an industry to figure out who the best player is. And so, let’s assume that’s what we call the stage one of our process which is our idea generation. And then stage two is what we call qualify. And this is where you are trying to figure out, what is the security? Is this a Buffett or is this a Graham? Because it’s going to determine the margin of safety required when you wanna buy it, it’s gonna determine, we wanna preset our sell discipline, kind of understanding what you’re going to do when it gets to fair value because you don’t wanna have to figure that out when it happens.
And so, this is where we are reading 10 Ks, reading 10 Qs, reading conference calls. This is kinda the preliminary look. Our research gets much deeper in our stage three but this is just to try to determine what kind of business it is. And so, our stage three is our deep dive and what I think is a little bit unique about our process that we have a team tackle structure. So, what that means is that we have a 5% investment team. Every idea that’s a potential to move forward has to have two longs, two people who are advocates, and then one short. So, we build in the devil’s advocate, so why do we do that? The reason we do that is because…
Meb: Is the short always the same person?
Ben: That is the question…I would say out of all the questions we get that is the most common question, and so this is the way I’ll answer that. Sometimes people are jumping up and down to be the short. If there’s anything that we’ve built, it’s a culture that allows people to express themselves, it allows people to accept and give criticism without fear of retribution. And I think…
Meb: It sounds like you have the Bridgewater Dot app.
Ben: I wouldn’t say like that radical transparency that the Bridgewater motto is a quite good description of us. I just think we’re really comfortable with each other and we created…and the process breeds discussion. And sometimes there’s dissension and sometimes we have to fight it out. But I would say it’s very rare that anything gets taken personally. I mean maybe like a couple of times in our history has that ever happened and we’re all close-knit and we can work it out and that’s the way its been. And then sometimes…to answer your question, sometimes everyone kinda tries to walk out the room when Jeff or I’m looking, you know, who’s gonna be the short because it’s such a good business at a compelling valuation, like, who wants to try to short this?
But we build this in to be able to…what Greenblatt says, he calls it, “Killing the idea.” This is Joel Greenblatt, kill the idea. Have someone whose job it is to be the short, be the devil’s advocate, come up with reasons why we shouldn’t own something. Because the truth of the matter is, if you run a concentrated portfolio with a long-term time horizon, you should be passing on more things than not. And if you’re passing on 9 out of 10 or 19 out of 20 ideas, there should be a really high hurdle. And part of that high hurdle comes from having the short.
Meb: By the way, just real quick, the portfolio ends up being what, like 30, 40 names?
Ben: So, in our small cap strategy, 30 to 39, in our small cap plus strategy, 20 to 29. Small cap plus strategy, there’s more liquidity in these stocks and it allows for a little more concentration. And you’re also, by and large, investing in better business so a little bit more concentration is justified.
Meb: Back to the process, the short, it’s more of a duck, duck, goose, not the one crazy person all the time doing it. What happens then? Do you guys debate it, is it a vote? How does it go down?
Ben: So, in our small cap strategy, Jeff has been running the strategy since I think 1992. He’s the portfolio manager and he makes the final decision. But the interesting thing about our process is that it’s designed to mitigate behavioral biases. We build in all of these checklist items in order to mitigate, to diminish the number of times that you can be biased by outside influences. And our final decision-making process and our step four of our process really embodies that. And so, let me explain. And so, anybody who’s worked on the idea, so let’s call it two longs and one short, everybody weighs in on the decision. So, it’s not just that there’s a lead analyst who is doing all the work and just throws the idea up to the portfolio manager and magically either gets in the portfolio or doesn’t. Everybody has to weigh in and why do we do that? Because we don’t wanna be subject to hindsight bias in the future.
So, what is hindsight bias? Hindsight bias, an example of that would be 3 years later, someone notices that a stock they talked about in the past has gone from 10 to 40. And then goes back and says, “Hey, I said we should have bought that at 10.” There’s no record of it, it’s all he said, she said. We record all of our decisions and so that we can say, “You know what, actually you didn’t. You said we shouldn’t buy it,” or, “That’s right, you were right.” And then we can relook at our process and say, “What did we miss here?”
Meb: Do you guys do like a New Year’s highlight and blooper reel like “Sports Center” where it’s like Ben pitching some stock, it just goes to zero and everyone is like, “This is so dumb.” You’re like, “No, this sounds amazing. I swear we should short Beyond Food.” You guys don’t do any short.
Ben: Yeah, we don’t do short.
Meb: I swear we should buy Beyond at $220, $14 billion market cap.
Ben: Thankfully, nothing I’ve ever recommend has gone to zero but it’s more that we chide each other. But in all seriousness about it, it allows you to go back and look at what you were thinking. And especially if it’s something you own, you can go back a few years later and say, “Where have we been right in our original investment premise and where have we been inaccurate?” And so, by recording all your decisions and doing that over time, so every decision note in the future you’re also recording your decisions, it allows you to understand what you were thinking at that time and look at systematic biases in your process over time.
And then the other interesting thing that happens is that when we are recommending an idea, the portfolio manager goes last, and why is that? Because he wants our unvarnished opinion. He doesn’t want what he’s gonna do to influence our opinion. So, if he said, “Yeah, I think we should own this,” then maybe, depending on the culture, maybe I’ll say, “Oh, yeah, of course, just follow the boss.” And he doesn’t want that. He wants to really know what we think. And if there’s anything about out culture, nobody is shy about sharing what they think.
Meb: So, let’s say it makes it to that point where you guys have identified, presented, I guess the next step you buy it. What is the thinking, you eluded to this, I don’t know if you guys do this but many, many investors probably spend, I don’t know, 95% of their time on everything that leads up to the buy decision and then that’s kinda it. But thinking of the sell decision before you initiate a position is probably as important, if not more. So, how do you guys think about that? You mentioned maybe price targets, you mentioned. How do you think about the concept of getting out particularly ahead of time?
Ben: Yeah. So, we preset our sell discipline. And as I mentioned, it depends on whether it’s a Buffett or a Graham. And so, let’s think about why we sell. So, the best example is you buy something, it gets bought by a larger company and that’s an easy one. And so, that doesn’t matter whether it’s a Buffett or a Graham. For a Graham, there are two things you’re looking for. One, you’re looking for the margin of safety to be close by price appreciation. And if you determine this is a Graham, you’re a seller. The harder part comes when it’s not working. When the stock goes down, for example, it was really, really cheap and now it’s really, really cheap. All right. They maybe add another really.
And so, the answer to that is you are relooking at all of your work to determine whether the business model has suffered some kind of permanent impairment. Has there been permanent impairment at capital? Has something changed about either your understanding of the industry or your understanding of people or understanding of the individual business that would cause you to say, “Whatever it is, it’s not working, and our original premise was wrong?” Because I would say one of the hardest things to do is to buy a Graham when it’s going down. A Buffett, if you think it’s getting more valuable every day, you’re almost excited when it goes down. But with the Graham, it’s not. And so, what we really wanna see is has something fundamentally changed about the business model?
Meb: The challenge to that is there’s always this like doubt creeping in of what did we miss? What does the market know? What do the insiders know? What does someone know that this keeps going down that we’ve overlooked? And it’s that feeling of omission that’s like in the pit of your stomach, the half of you that feels, “Hey, we know this better than anyone. We’re happy this is going down, we can buy more.” But to me, there’s always that feeling of, “Oh, God, what did we miss? Is there something out there that we clearly just skipped over and we’re just taking it?”
Ben: There’s nothing more painful than buying a stock after it’s gone down. And I think you have to be really selective given the securities you’ll do that with. My sense as a Buffetty-oriented investor is that you wanna do that with businesses that you think are unequivocally getting more valuable every day. And if you have concerns about it, I think you need to be much more careful doubling down when a stock is down. And so getting to your question, when do we sell a Buffett? We sell a Buffett when it gets to evaluation that is just absurd.
And we may talk about this a little bit in terms of what’s going on in the market but that’s one of the challenges with a Buffett-oriented strategy right now is that we see really good businesses that are growing that have really nice modes and good management teams. We see the trading evaluations they’ve never traded at and multiple, multiple turns over their historical numbers. And that makes us a little nervous because you can, as a nifty to 50 will tell you, “Just because you’re investing in good businesses doesn’t mean that you’re gonna make money. The only thing you can determine is the price you pay.”
Meb: I think it’s a lesson that’s really hard for particularly younger investors to learn, which is you could have a great business but you still got to pay attention to the price. And Munger, I think, talks a lot about this. He’s like, “Look, if it’s going really fast, you can kinda grow into that price. But if you pay a really high price, it’s hard. It just sets the bar so high that you have to have this amazing business just crush it but that’s the challenge. You kinda led into this. Maybe talk to us a little bit about what’s the world look like in 2019? You’ve been at this for, man, almost a decade at Cove Street. What’s changed? Nothing changed, everything changed, what’s been going on in the world?
Ben: Well, as you highlighted, value investing is somewhat out of favour. If you just look at the Russel 2000 growth versus Russel 2000 value, growth has them outperformed in every single period over the last 10 years. But on a whole over the last 10 years, it has just been stomping when it comes to growth versus value. And I think the other thing that’s really changed and influences us is the move from active to passive. When the S&P 500 or the index has done really well, institutional investors, for a good reason, question why they should be paying active management fees. And the simple answer to that is that let’s see what happens the next time there’s a downturn. Because that’s when you remember that if you invest in managers who are able to protect capital in a down market, that’s where they can add a lot of value. But we haven’t seen very many down markets. And I think we saw Q4 2018, just a little glimpse of what it would look like and I would say after your management, by and large, did pretty well from what I’ve seen over that period of time.
So, there have been a number of headwinds and, as I talked about, valuations broadly may be somewhat stretched in the really good businesses we own. But let me say, value investing…and I just…if you’re interested, covestreetcapital.com, in our blog, I just published the quarterly letter I wrote. And one of the questions that we keep getting from any number of different areas is, is value investing dead? Is this a strategy that no longer works? And my simple answer to that is that value investing is not one thing. Buying an asset for less than its worth, buying something for less than its intrinsic value is evergreen because there will always be opportunities to do that in different markets at different times, at different cycles.
And so, if you’re asking, is Ben Graham’s style of investing potentially no longer a valid strategy? Yeah. I mean how many net-nets do you see in the market these days? I mean where do you find an investment that’s purely a good investment just based on the strength of the balance sheet and the value of the balance sheet? We don’t see much of that. But when you are investing institutional assets in concentrated portfolios, you don’t need that many new ideas. So stocks can be expensive, broadly, but if you only need one or two new ideas a year, you can find them. And where do you find ideas these days? I would say anything tied to China has gotten cheap. If you wanna touch the auto sector in any way, shape, or form, just about anything that touches auto is cheap. Domestic U.S. industrials are starting to be a little more interesting.
Look, there are some cyclicality across all of that. And so, what you want to do, I think, is you wanna own really good businesses that are “growth cyclicals,” things that are getting more valuable over time but they have these bouts of cyclicality just based on what happens on the end markets. And you can buy them, ideally you kinda buy it at a half position now and then you buy it on the way down, find a business that you get excited to buy on the way down. So, that’s the broad view of the market. I mean we come in every day without a lot of thought about the macro. You know, I can talk about this within our process. We definitely, certainly with every single idea think about how the macro could impact it. But we don’t come in thinking, “Oh, we hit the market, we should be in cash,” or we’re worried about what the Fed is gonna do.
These are all inputs into our decisions but really it’s a bottom-up portfolio, looking for securities that are getting more valuable every day. Finding stocks and companies that are run by really good people. Those people take advantage of downturns. Everyone else gets afraid of the cycle and these people are prepared for it. They have a great balance sheet and they’re scooping up all the competitors. And so, getting to the broader point is value investing will always have a place and there will be a time when being a value investor doesn’t look like you are out of touch with the market.
Meb: You touched on a couple interesting points. One I was laughing at because you talked about the macro influences and your methodology is, frankly, the way that it should be. You’ve seen so many instances where a lot of old-school stock pickers get bigger, they start to get influenced and start to make more macro bets. The most famous, of course, would probably be Julian Robertson in the late ’90s. But I don’t know if it’s Joe Weisenthal or someone else who coined the original phrase, “macro bullshitters.” But it’s like you want your stock picker, they can write in the letter and they can gossip about it at happy hour but that’s the extent the macro should start to creep in because it’s so, so hard. Discretionary macro has to be the hardest thing on the planet, I can imagine.
And couple of things I thought was pretty interesting. One is I look over y’all’s portfolio. I love it because my favorite portfolios of firms to look at have a bunch of names that I’ve either never heard of or they just like sound so boring. It’s got like an acronym and it’s a name. The number one holding is a holding we actually wrote about on the wall up there years ago, at least in the mutual fund. It maybe dated, I know it’s a longtime holding of Baupost, which is a fun one. But are there any sort of…you mentioned a couple of sectors. Auto, this is really interesting. That’s one of those sectors that I feel like has such tectonic forces happening with 10 years from now, who knows what we’re all gonna be zooming around in. I doubt our children are probably gonna even ever learn to drive other than on like a farm or amusement park at some point, I don’t know. Anything else popping up you think is interesting, worth a look, something we should shy away from?
Ben: I think broadly what you should be really careful of are businesses that have been doing extraordinarily well basically since the end of the cycle. It’s kind of the 2009 period. It has been unabated rise in margins, in multiple, in expectations. And people have forgotten that there was some cyclicality and there are cyclicality in every business. I think what we’ve seen is just these businesses that get this halo and they trade in multiples that I don’t think are justified even how great the business is. Because no one is immune and there’s going to be a time where you suffer the double whammy of reduced expectations, reduced cash flows. And then, while all of a sudden you’re not gonna be afforded that same multiple.
And so, I think you wanna be…you know, again, it’s like the nifty to 50 curse, and this is what we see in the market. Things get incredible, stocks get incredible valuations, and the multiples continue to expand until they hit an earning speed bump and then we see it down 20% or 30%, right? The market has become very sceptical and skittish about things that are no longer on this trajectory that was always unattainable. But whatever it is, you wanna blame it on low interest rates, you wanna blame it on whatever it is. There is this demand for these great businesses.
Meb: The Fed, you can blame it on the Fed.
Meb: Today is a Fed day. So, you guys manage about a billion dollars, you have a very institutional business. So, listeners, unless you got $10 million to allocate, the good news is there’s a mutual fund. But have you noticed any difference in the behaviour, or flows, or anything between being an institutional as well as a more public offering? Do you guys have any general comments? When did the mutual fund launch? That was well after the start of the firm though, right?
Ben: No, no, Jeff Bronchick managed the mutual fund for a long time. I think our track of the mutual fund goes back to the ’90s so, I mean, there’s a long track record here of Jeff being in charge of this mutual fund. You know, I think Cove Street was designed to be more of an institutional firm. We could have gone either way, you could have a hybrid. I think what we wanted as a firm is we wanted fewer clients, fewer relationships, more meaningful. I mean our favourite clients are the ones who beat us up for two years before they make an investment. Because want people to understand who we are.
We’re concentrated value investors, and what is that mean? That means that at certain times, our returns are not gonna look anything like the markets. And sometimes we look really, really smart and at times we look kinda silly. And especially if you’re measuring us on a quarterly basis, you’re gonna see a fair amount of, you know, what they call tracking error and you’re gonna have a really high active share, and these are things that it’s endemic to our strategy. And so, I think the way we were structured and the way we have limited the number of people out there selling us and marketing, we just really wanted to have a bunch of clients who knew us, who are willing to write decent-sized checks, and then we’ll service a small number much better than we could a much broader institution.
And so, I think to be in the retail world, I mean you do something a little different with the ETF, but like to have a lot of mutual fund coverage and to have that beyond every platform, you know, you need a fairly large sales team and we wanna be investment-led as opposed to marketing-led. From the very beginning of Cove Street, we had a goal of getting to a certain level in our small cap strategy and closing. That was our goal, to close. I mean I don’t know many people who start their firm with the idea to close but the reason you do that in small cap is if you get too large, you lose the ability to invest in smaller companies, things that are liquid, things that are misunderstood or underappreciated that other people aren’t paying attention to.
And so, the firm was designed not to be an asset gatherer and so that’s why we’ve kinda chosen the institutional route. And without any question, it is hard. When you wanna have meetings with the top endowments, you can get the meetings but get them to pay attention to you. They wanna watch you for three years. They wanna see, they really want to understand how the beast moves, which is great, and we like to see that and we maintain relationships with these people so that when their asset allocation changes and small cap value’s all of a sudden in favour, we’re gonna be at the top of the list, and so you position yourself for those moments.
Meb: All right. Summer of 2019, anything else you guys are looking at?
Ben: So, as I mentioned, business, value, and people are our three pillars, and we haven’t really touched on this to the degree that would reflect how important it is in our process but the people part is really something that we think about every day. It is something we try to understand with great depth. So, corporate governance is something that is a huge part of our process, understanding corporate governance. And so, what is that mean? That means understanding people’s motivations, understanding people’s histories, understanding board dynamics, doing everything you can to try to not quantify but understand unquantifiable. I was fortunate enough to be able to participate in the undergraduate value investing program at UCLA. Bill Simon who I think is probably the best known for running for governor of California is in charge of the value investing program with UCLA undergrads and I’ve developed a relationship with him.
And, as I said, I was fortunate enough to be able to spend three hours teaching the students about value investing. And he has Howard Marsh come to speak to them and I can’t compete with that name cache. But what I thought I could do is I could give them exposure to something that they don’t have exposure to, which is the process of trying to understand management and the board and through the lens of the proxy statement, which we think is probably the most underused public filing that exists out there.
Meb: Let’s unpack that. Explain what the proxy statement is to all listeners and why they should get excited about reading it.
Ben: Well, I’ll never say a proxy statement is an exciting thing to read. It is a gold mine of information about people’s incentives but it’s not something that’s stimulating in the same way that reading about the business or listening to Jim Kramer talk about stocks. It’s not…you know, there’s no excitability in it. What it is is a list of different compensation and governance policies that we fundamentally believe are gonna dictate the direction of the company.
So, let me unpack that a little bit. So, if you want to understand what someone is going to do within the corporate context, you can know based on how they’re compensated. We scrutinize a proxy statement to understand where their comp is derived from. Is it based on earnings per share? Is it based on the stock price? Or is it based on things that we really care about such as free cash flow, return on invested capital? These are the things that we think drive value over time. And if you’re making an investment in the company where the CEO is only compensated on something like quarterly earnings, well, you know what that person is gonna do. That person’s incentive is gonna be to maximize quarterly earnings potentially at the expense of the long run.
And so, we wanna see structures and organizations and incentivize people to invest for the long run. Now, we want people to have some return hurdle for that investment baked into their compensation but we don’t want people to be focused on just making next quarter’s numbers and not investing in R&D. And so, three years from now you have a dry pipeline. And so, the proxy statement, just reading one of them, you’re not gonna get much context. But when we vote every single proxy that we get and we have a program where the person…there is a single person in charge of voting all over the proxies. And so, that person get exposure to dozens and dozens of proxies and gets to be able to compare across the proxies. And just to see like how are different people compensated? How are they incented? What are the different corporate governance structure? And when you read that many of them, you start to get a feel for what’s good corporate governance, what’s a good comp structure, and what’s totally off and potentially distorting in a certain way.
Meb: It seems, given all the rhetoric and everything the politicians are talking about today, I often say that it seems fairly misguided that the boogeyman is buybacks, which is what they’ve all globed on to. And I don’t understand why more focus isn’t at the board level, for example, why in the world companies still in 2019 link compensation to, say, share price or EPS. That just seems like such a crazy thing to do that just comes up with weird incentives. I don’t see why there’s not more focus on that or why companies continue to do it other than maybe it’s in some board proxy how-to manual from like 20 years ago.
Ben: If there’s a boogeyman, it should be the quarterly earnings cycle or the idea that people are measured based on what happens every 90 days. Businesses and their intrinsic value do not change that greatly in 90 days but the stock market based on the reaction to missing earnings by a penny would suggest to you that businesses change very rapidly. Now, that’s an opportunity for value investors but you have to be really careful to make sure that the business that you’re looking at and the company you’re looking at have the right incentives. And so, as you’re saying, Meb, if you’re incentivized based on EPS, what’s a great way to boost EPS is just to buy back your stock. But what if there’s a better use of that capital? What if there are acquisitions you can make? What if you should be investing aggressively in R&D, actually depressing your EPS, because you have an incredible product or solution for your customers but you’re not incentivized that way?
And so, I think what all this means, and getting to what I said to the students, is like this is a really, really hard thing to quantify. Like if you think about the business, you can quantify good business, good returns, good margins. If you wanna talk about value, right, that’s a number, right? Like the margin of safety is a quantifiable number. Is management good or bad is a very difficult thing to quantify. And what I told the students is that just because it’s hard doesn’t mean you could ignore it. You have to run through a checklist of things to try to determine whether these people are friend or foe. And I think Cove Street, we see ourselves as suggestivists, which is different from an activist. We don’t wake up every day thinking that we wanna cause trouble in board rooms. It’s a very, I think, nerve-wracking way to live.
What we have is we have a very open dialogue with the companies that we invest in about governance, about compensation. We know we’re not smart enough to tell people how to run their businesses but we do think we know a little something about the way to structure a comp plan and about how to have proper corporate governance from a board level. These are things that we think that, you know, when you read these many proxies, when you’ve been in the business as long as I have and as Jeff Bronchick has, right, I think we feel like we have a pretty good sense. And the other thing is we invest in a lot of companies and we read lots and lots of filings. So, we can compare across industries, across companies in a way that management teams might not be able to and board members might not have kind of the understanding of it.
Meb: I’m always surprised this sort of thing isn’t more boiler play as far as what’s commonly accepted good behaviour where you have these outliers and you’re like, “Look, what are you guys doing?” How often is it the case, you’re like, “Look, this is a good business and I actually think this is good management but the structure is just garbage,” and you reach out to them and be like, “You guys, what’s the deal?” and they’re like open to your suggestions. Does that never happen or is it fairly regular, or what’s the process when you’re suggestivising?
Ben: I would say it’s mixed but you’d be surprised at how many times it’s just…it’s not even neglect. This is one thing that I think people really need to understand. Most of the time, when bad things happen, good things happen, so much of it is based on luck and circumstance and very rarely is it based on malice, for example. What we see on boards is a lot of inertia. Some comp consultant seven years ago came up with a comp plan and no one’s really looked at it, and we see this especially in smaller companies. We feel like we can add a lot of value as a shareholder of a smaller company to just write a very simple letter to the board and say, “Hey, you know what, this is…We like you guys. When we talk to you, you say the right things but your proxy and your structure doesn’t match what you say.”
And my guess is, people don’t tell you this. My guess is other people see this mismatch and they turn it and say, “Well, why would we invest with these guys?” We raise our hand and say, “Hey, if you guys are doing a good job, why wouldn’t it be reflected in the proxy and the compensation?” And I would say a fair amount of time, people are receptive to that. I mean I think it’s about how you do it. If you’ve come to them like a partner, like you’re a shareholder, you’re a partner and you’re not an activist, and you’re not telling them to fire the CEO and buy back stock, no. This is about just making sure that the way that the business is run, people can be compensated well if it’s successful as opposed to, you know, maybe incentivizing the wrong outcomes. And so, I would say it’s surprisingly easy to get management’s ear if you have reasonable expectations and suggestions.
Meb: Are there any particular bad examples that come to mind as you’ve been going through these where you’re like, “Oh my God, that doesn’t even make sense?”
Ben: I’m gonna give you one and I’m not gonna name the company. And I’m sorry if this is gonna be a little bit in the weeds for some of your listeners but I think, Meb, you’ll really appreciate this. So, there’s a common practice on Wall Street where if you wanna put out some information that you don’t want people to see, you would put it out on a Friday or you put it out during the holidays, Christmas or New Year’s where you think that all of the investors are gone and no one’s gonna notice that you put something out. So, a company that we’re involved with put out a filing. The press release was December 28th but it didn’t actually get filed until like January 2nd. So, this is like no-man’s land in terms of no one’s paying attention, everyone is still hungover from the holidays. And so, they said in the press release that the CEO is gonna get a bonus for selling a couple of businesses.
Now, the issue, of course, was that they’re selling these businesses almost in distress. This isn’t like, “Hey, we had this great business that people were undervaluing and, you know, we separated it out and we’re getting a great multiple for it.” No, they needed to de-lever. This should have been part of being the CEO, this is a part of your job. This is not a special bonus moment. So, we saw this press release, we asked them about it. And then we expected to see the filing when it came out, when the first quarter 10-Q came out, it wasn’t there. So, that’s surprising. Well, what about the proxy statement? Well, it wasn’t in the proxy statement because the payment was in 2019, the proxy statement that came out recently only covered ’18 so it’s not in there.
And then to make matters worse, when we asked them why it wasn’t in the Q even though the bonus has been paid in Q1, it was buried and it was called “discontinued operations,” which is kind of a catch-all line where you can bury things from businesses that you’re selling or that you’re no longer operating. And so, if you weren’t paying attention, there was, you know, a very significant bonus that would suggest to you that these people have a distorted view of what shareholders care about that will not…may be never seen. We’ll see if it’s in the proxy that comes out next summer but, you know, it will basically be hidden for a year-and-a-half.
Meb: What I don’t understand is like, you think in 2019, in this day and age, it’s almost like doing a press release or announcement Friday night or the holidays is like a red flag. It’s like everyone is watching now. We had Michelle from Footnote and she was an early guest on the podcast and she’s like, “That’s literally my job is I sit there and read all of these and flag them and post them on my newsletters and Twitter.” I was like, “If I would do it, I’d probably do on like Monday now, get off-cycle as to where you’re not gonna red flag it.” But it’s so funny that people still do things like this.
Ben: I would say that, and not to denigrate other people in our industry, but unfortunately, a lot of people get their information from the sales side. The sales siders, they are conflicted in the sense that they want access to management, they wanna take them on road shows. They wanna be able to call and ask them questions. And so, if they criticize a bonus that came out in December 28th, they may get black-balled or, you know, they may not be able to take them on the road show this year. And so, what happens is if they’re your gate keeper, there’s a potential…you have to recognize a conflict and they may not be willing to criticize management. They may not be willing to point out things that happen like this.
And so, that’s why you have to read every filing because companies…and this is part of the corporate governance, companies will bury things in what’s seemingly an innocuous AK, which is just kind of an inter-quarter filing. They will say, “Hey, yeah, we hired a new chief commercial officer.” And then at the bottom of the press release, they say, “Oh, we’re also taking a $50 million charge for bad debt,” like something completely out of left field and so you have to read every filing. And Michelle, we’ve talked to Michelle before, she will always have a job until the AI comes and is able to read every financial statement and solve problems for you.
Meb: Listen, companies, Ben and Michelle will find you. There’s no way to hide any of these things. I think the best description I’ve heard of the sales side is they do a very good job of describing a lot of what…is the base case well known at a company? It’s like this is what pretty much everyone understands and we all know. It’s like going that extra distance where you’ll find things that, whether for malice or not, or hidden, or buried, or just not focused on, etc. But proxy statement, man, I don’t even think we’ve covered proxy statement in the 170 episodes yet.
Ben: Just getting on that. So, when I went into the UCLA class, I asked the students, “How many of you have ever read…” I assigned them two proxy statements to read. I said, “How many of you had ever read a proxy statement before that?” I think 1 out of 30 raised their hand. And the funny thing is…
Meb: The one was confused and thought you were talking about something else.
Ben: Yeah, yeah. No, someone else thought…It’s not just about the proxy. The proxy is kinda the manifestation of a lot of things but really what it is is having a checklist like we have of corporate governance items. And going through that one by one as you try to determine whether these people are going to be, and we joke about this but we’re kinda serious, are they stealing for you or they’re stealing from you? And you really want to understand that, especially if you’re taking a three to five-year time horizon, ideally forever time horizon. I think the business is going to drive a lot of what happens and determine a lot of your returns.
But think how much…if you’re a CEO for 10 years, how much of the company’s asset base will you allocate over that 10-year period? And if you don’t have a capital allocation framework that is grounded and return on invested capital, that is grounded on generating free cash flow, there’s a potential that you could totally misallocate that capital and destroy a really good business. I have a couple of quotes here from Buffett that joke about that, you know, you want a business that’s really easy to run because eventually, you know, if someone who’s incapable will run it…those aren’t the words he uses but…
Meb: You can say idiot.
Ben: Yeah, yeah.
Meb: It eventually will.
Ben: I’m being a little nicer about it. But, I mean, and some people might look at that and say, “Well, Buffett is saying that the manager doesn’t matter,” and that’s not what he’s saying. Because if you go to the Berkshire meeting, they spend a huge amount of time talking about how important the Berkshire managers are and, you know, every one of them gets a little shout out in the video. Because Buffett always wants to partner with, A, people with integrity, B, people who have a long-term time horizon, and people who work well in a really disaggregated, decentralized organization. And so, he talks a lot about how important partnerships are and he has an unbelievable advantage when they buy businesses to be able to know the management team and understand them and see the books.
We don’t have that opportunity so what we have to do is we have to dig in as many different crevices as we possibly can to understand. And what does that mean? That means we’re calling former employees, that means we’re asking people for references, that means we’re reading the conference calls from when they were CEO at another company. It means we’re just trying to go through as many different data points as possible. I see investing as kinda like painting a mosaic, and especially within this understanding management, you’re putting as many dots on the canvass as you possibly can to hope that once you’ve collected enough data points, you have a view. There’s a Picasso in front of you that you can actually say with some reasonable certainty that these people are either friend or foe.
Meb: That’s really well said. For me, that was always a hard…dealing with management was always, it’s easy to get, in my case, fooled. But also, at the same time, you know what, it’s funny, when you’re talking about doing the work, I mean I can’t tell you how many times we’ve been doing due diligence, and this isn’t even with securities but with service providers, with companies that we wanna partner with, anything, I’ll be like, “Okay, cool. We’ve gone through the whole process and like, send me three references, current, past, two of each, whatever.” And then they just fall off. They like won’t even send in references. They’re like, “You know, I’m done. You know, like I’m not gonna even send in. I’m just ending this process now.” I mean that has happened multiple times in the past year. We’ve spent like hours and hours going through this. I’m like, “All right, send me some references.” And then they’re just like, “Goodbye,” which seems crazy but like it’s a question that a lot of people don’t ask.
Ben: That would be a huge red flag for us. I think if you made it to be a public company CEO and you didn’t have anybody who would vouch for you…it takes a lot to get there, right? And you probably had to climb many number of ladders to get there and if you have stepped on every person in that path, I don’t think that you’re the kind of partner we wanna be with.
Meb: Go back to crevice digging, what are some other resources that you guys…it could be software, conferences, books, airplane magazines, anything. What are some things that you guys use in the process that you think is particularly useful?
Ben: So, we are prolific users of LinkedIn, where we go on LinkedIn and find either mostly former employees of the company or people who work with their management team and we reach out to them. And you’d be shocked at how many people are just totally happy to talk about their former employers or their former boss. And so, that’s a really good venue for getting totally unvarnished thoughts on people.
Meb: The only reason I log into LinkedIn is to log on, read the seven spam messages, log off.
Ben: Yeah. LinkedIn is a gold mine. The other thing we do, we use expert networks pretty regularly as well. And I think expert networks get a bad name in the sense, just mainly because of the things that happened with Gerson Lehrman and all of, you know, insider trading stuff. And look, there are certain people who want to talk and find inside information. We have no interest in inside information. What we want is we want to understand the business better, we want to understand the people better.
Meb: It’s almost like therapy for a lot of these people, too. They’ve like been waiting for someone to let them complain about their boss, or crappy former company, or competitor industry or whatever. It’s like it should almost be like a free expert network and just call it therapy.
Ben: You know, the funny thing is, Meb, I would say more often than not, people have very glowing things to say about their former company. And so, you have to be very careful of bias on either side. Either you could have a disgruntled person or just someone who does not have an unbiased view of the management team or the company. So, I think you need to talk to enough people that…you know, you never gonna…we don’t have the resources to talk about a thousand people but we can talk to 5 or 10 and get a sense of what people think of the management team, but even more so the business. I think one of the things that we get from this is not just a very cursory understanding but what is their actual go-to-market strategy or what are their customers like?
You get a really…and when you talk to somebody especially who’s not in the C-level but somewhere up in management but not the C-level, I think you get in the weeds more with these people. And so that when you are developing your narrative about the business, you’re much more fluent in what they actually do as opposed to what they write in the 10-K, which is not necessarily distorted but you just can’t write your whole business model in an annual filing. It has to be a summary.
Meb: As you think about these actual interviews, too, a lot of people will go through this very lighthearted, like, “Ah, I’m just gonna check the box. I’m gonna talk to this reference to try to get some information.” And it’s very important the kind and types of questions that people ask because like a lot of people will, you know, ask me…they’ll call, like, ask for a reference. They’d be like, “How do you know so and so? Was he a great employee?” I’m like, “Dude, I’m just gonna give you the…” Here’s a good example of a great question to ask, and they’re like, “You clearly like this person but for someone who doesn’t like this person, like what would they say about them?” I’m like, “Oh, that’s…” And it went on for like two…I’m like, “Oh, my god, this is what they would say. I wouldn’t say this but a lot of people will.” And after like two minutes like I can’t believe I just volunteered that information. It’s like that’s such a good question. It’s not a trick but it’s a behavioral, thoughtful way of getting the information you want. Most people wouldn’t think that you got to actually think about it. It’s almost like an interrogation tactic.
Ben: So, we asked almost solely…except when you’re talking to CFO and you want to understand a numbers question. We ask solely behavioural questions, what ifs. What would you do if this happened? This is when we’re talking to management. Of I gave you a $100 million in capital, what would you do with it? I mean we want to understand how people think. And when we’re talking to people who used to work for the management, you know, were they either a company or management team, it’s all about behavioural questions. So, A, why did you leave the company? Did you leave on good terms? Was it a good company to work for? So, those are the standards but then let’s dig a little deeper. Where are their strengths? Where are their weaknesses? Would you work for them again?
These are the kind of things we want to understand so that…look, people could just check the box in an interview like this. Oh, this person like them, they thought they were smart, but what is that mean? What are their strengths? Are they good with people or are they kinda command and control? What is their style? So, these are the things we’re trying to understand. And if you’re looking at this process and asking yourself like what in the world is all of this for? What do you get out of all of this? And I can’t say, there’s no…One of the hardest things in investing and being a professional investor is allocating your time.
And so, I could see someone looking at us and saying, “All the time you spend trying to understand management, is it worth your time?” And I would say, “Unequivocally, yes.” Because if you’re looking for a partnership, you’re looking for a three to five-year partnership, you want to understand what people’s motivations are. You want to understand their style, you want to understand the depth of their knowledge about the business. Are they kind of the high-level guy or are they in the weeds? And these are the things that are important to us because we have three pillars, business, value, and people. And if you get the business and value right, maybe at times it works out well. But to get a compounder, to get one of those multi-baggers, to get a career-maker, I think you need the business, value, and people altogether, and so that’s why we spend the time on it.
Meb: Going back to Buffett again, I mean he’s had some classic behavioural questions where I think the most famous might have been, “If you could have a gun and shoot one competitor, who would it be?” And that’s such a good question. It just gets right to the matter of basically who’s the best in your industry that you know.
Ben: We also call competitors to the degree that we can and if you want the bear case for your company, talk to somebody who works in sales for the competitor, they will give it to you. And then sometimes, you know what, every once in a while they’ll be like, you know what, the competitor will say, “They’re just better than us.” And that’s what you want to hear is a competitor who every day is out there fighting in the trenches to beat the company you’re looking at but there’s a recognition that whatever it is, the technology, the go-to-market strategy, the infrastructure, it’s just better. And that’s, I think, a really good endorsement when you hear someone else begrudgingly say, “Yeah, these guys are really good.”
Meb: How much of your time is actually spent on these kind of more qualitative, I guess some of it is quantitative, but whether it’s on the road or chatting with management, chatting with competitors, less the kinda hard, quantitative screens? It sounds like it’s a pretty significant amount.
Ben: Yeah. We’re way more focused on the qualitative and I don’t wanna diminish the importance of the quantitative side. But the reason why I talk about it this way is the quantitative side, everyone does that. Everyone has a model of some kind, everyone does some of the parts so these are things that are standard and everyone has a capital IQ or Bloomberg populated spreadsheet that can look at the returns on capital and say, “Is this a good business or is this a bad business?” So, there’s some nuance there and I’m generalizing a little bit. But for the most part, if you do that, if you just have Bloomberg and some kind of DCF then you can cover the business and the value pretty well. But the nuances of the business, how do they really work and what’s the competitive sell? Like what is the industry structure? Those are the things that’s the really qualitative part and then the management part is basically 100% qualitative.
And so, we…I’ll tell you, like we were looking at an animal health company and it’s a controlled company. There’s this controlling shareholder and we wanna meet the guy. So, it was one of those times where we went to New York and there’s like no one else could take a meeting. So, we flew to New York and drove to New Jersey just for a meeting. We spent 90 minutes with the CEO and he changed…because you creates these own narratives about a company.
Meb: [crosstalk 01:03:28] negative.
Ben: Positive. I think we thought of him as kind of a…I don’t know what we thought but he came off as a very savvy capital allocator, understood capital markets to a degree that we weren’t sure of, and understood so many CEOs and it’s just, it’s hard. Maybe you come up from sales and, you know, maybe your CFO and then you become the CEO, it’s really hard to understand what people at our side of the table actually care about. And so, a lot of the time you’re talking to someone, there’s no malice, they’re not bad people, they don’t understand our framework. And maybe they’re really good at sales, maybe they’re really good at managing people. And so just, you know, having a dialogue helps you establish a common ground. And so with this gentleman, I think he had it, like, he gets it. He understands capital allocation, he understands what his company is worth and has an exit plan, and talks candidly about those things, which a lot of people don’t. So, I think it’s very important for us to, in most of our investments, meet management face to face but for sure create a dialogue over the phone if meetings, you know, within the time frame don’t make sense.
Meb: It’s important. I mean you touched on it a lot today and I think the great book, “The Outsiders,” is one of the best about capital allocations. I mean so many people, I mean it’s journalist, everyone that wants to be talking about a company, its success, it’s failure, focuses purely on the sexiest part, which is new products, performance, mergers and acquisitions. But as I mentioned earlier, all those decisions matter across the whole quiver of capital allocation. Maybe it’s taking on debt, paying it down, paying a dividend, all that fun stuff. Any resources that have been particularly influential for you over the years, any books, any…it can be concepts, it can be anything else that was a big influence to you?
Ben: So, I’ll give a couple of things that maybe that are kinda top of mind. We just started to subscribe to a service called Infiling. What Infiling is is it’s kind of…what they do is they scan companies’ SCC filings for changes. So, one of the issues with doing what we do is you read a document but you don’t have a whole lot of context regarding what was in the document the year before. So, let’s say we read the Q2 10-Q for a company for this year. Well, what did it say last year? Were there any changes? Were there any material changes? Did they change auditors? Did they change their disclosure with their risk factors, or something like that? So, this interesting software goes through and it highlights changes.
And so, that you can see, again, getting to, you know, kinda the footnote of thing. Like we read the footnotes but the nuance there is that if you don’t know what was in the previous footnote, you can’t see what was changed. So, you can look at it in the vacuum and say, “All right, well, that seems kinda strange, but okay.” But then you go back and you see, “Wow, look, they had a reserve that was $40 million last year and now it’s $200 million this year, like well, that’s a big number. What’s going on here?” And so it’s everything about our research in whether it’s the business or management, we’re looking for outliers. We’re looking for things that stand out either positively or negatively. And this is just another way for us to monitor the way the companies file, the way the companies report, right? Are they changing their segments all the time? I mean I’ve got a list of red flags here of things that we look for.
And are they changing the list of litigation, right? All of a sudden a bunch of new lawsuits show up and these are the things that are in the footnotes that are incredibly…they are written in legalese, they’re dry, they’re boring. Even for someone who does this all the time, I’m not a lawyer, still very difficult to totally parse all of the commentary. And so this, what it does is it’s a quick way to flying things and so something has changed. We’re gonna read the Q and the K and the proxy anyway but at least this gives you some context. And so, again, it’s all about, this is a portion of understanding management and understanding corporate governance. I think people underestimate press releases and Ks and Qs are very, very carefully written.
No one is out there just like scribbling things, I mean lawyers have gone through this, the compliance officer has gone through this. They may even have the PR people going through this, like everyone wants to think about…you know, there’s probably arguments whether it should be a “the” or an “and,” you know what I’m saying? These things are really well scrutinized and so if companies make changes, it is deliberate. These are things that…well, outside of fraud, these are things that people can’t hide. So, that’s a resource that we start subscribing to and it’s a time saver.
I mean if you’ve ever been to an earning season…I mean, again, I’m complaining about quarterly earnings again maybe because we’re in it and maybe because I think it’s just such a waste of time. And it would be great if companies reported once or twice a year instead of four times a year. But when there’s a million things going on and a bunch of companies are filing and things are whipping around, even for long-term investors, you’re drinking through a fire hose. And to be able to have this Infiling system to say, “Hey, this company just filed a Q, they just changed their risk factors.” Well, let’s see what that is. And for the most part, what is it gonna do? It’s maybe at least to a call of management, maybe we need to understand this better. But, again, it’s another dot on the paintings and maybe it changes the picture a little bit the more of these things you put on there.
Meb: That’s a good one. Never heard of it, pretty interesting tool. We had…one of our recent guests was Bill Martin who runs a hedge fund but had helped start Insider Scores, which is another fun one. It lets you track buying and selling from insiders. We have long been fans of looking at the filings of other fund managers to see what they’re up to for idea generation. A podcast I was listening to the other day, I wanna say it with as with an Aussie short seller Hempton and he’s talking about also following lists. He’s like, “Success leaves traces but the opposite is true where you have just highly questionable, unethical CEOs that have failed 2, 4, 6, 8, 10 times in a row.” He’s like, “That’s a great list to have because if you’re a newbie analyst, you come along and you don’t have that piece of information, that’s pretty useful information to have,” you know? This guy has just been a consistent capital destroyer. Things like that I think are fascinating. Always the laundry list of more things to do. Anything else come to mind? Any other…
Ben: Just a little note on that, I mean the flip side is also true. There are certain managers who we follow intentionally. So, we say, “Well, there’s a specific guy who sold the company we own and we’ve been following him just waiting for him to pop up somewhere new.” Someone who has successfully built and sold a number of businesses, those are the kind of capital allocators we wanna partner with, right? I mean you don’t get stupid overnight, right? And if you’ve been able to navigate the public waters and create value for shareholders multiple times, that sounds like someone who understands how to make it work and understands being long term, thinking about returns, these are the things that we care about. And so, it’s not just a negative screen, it can be a very positive screen to see what people have done in the past.
Meb: Very cool. All right. So, I guess we’re winding down, I can’t keep you forever. We always ask people, I love this question, in your own personal career, and this could be at Cove Street too, any of the most memorable investment that you’ve ever had, long, short, neither, both, good, bad, anything comes to mind?
Ben: Yeah. I mean anybody who knows me will recognize that if there’s any affliction I have it is loss aversion. So, I feel the pain of losses far more than the euphoria of success. And so, I don’t wanna talk about the company specifically but I will talk about the circumstances and how it basically framed my view on investing in smaller companies. And so, we had a retail-ish oriented company that had a major customer. The major customer, they’ve been with them for like 17 years. And one day that customer walked away and set off a spiral that this company has not been able to get out, away from, right? So, what happens when one of your customers walks away, you do whatever you can to plug that hole. There was a capital allocation decision and acquisition that was made that wasn’t done particularly well.
And this small company was not able to handle the fallout from a poor acquisition and losing its main customer. And what was a good returns company that had a CEO who had come in and done a great job, and had a multi-bagger of a stock, now it’s lost 90% of its value. What did that teach me? You know, you never want to overgeneralize. You don’t wanna just assume that every situation is gonna be the same. But here’s what I really took away from that is you want to own businesses that can take a punch, whether that’s because they’re large enough to take a punch or whether they have largest customers 1% and not 40%. You want businesses that have, obviously anti-fragility would be the best, but just some buffer against things going really poorly. And what we see often in smaller companies is that they either have single market risk, or customer concentration risk or, you know, single product risk if its a medical device company.
You know, inevitably, bad things happen. And just like Buffett says, right, he guarantees that at some point or at any moment, there’s someone at Berkshire Hathaway who’s doing a bad thing, right? They have hundreds of thousands of employees, someone is doing the wrong thing. One employee doing the wrong thing at Berkshire is probably not gonna bring down Berkshire. The CFO doing the wrong thing at a small publicly-traded company could be the end of that company and the end of…you know, a zero in your investment. And so, I’m not trying to denigrate smaller companies because this can happen at larger companies, too. But the real point is you’ re really care about customer concentration, product concentration.
You wanna invest in businesses that have diversified revenue stream and diversified customer basis and diversified end market basis so that when that inevitable bump in the road happens, maybe a stock goes down but you don’t go from a $27 stock to a 40 cent stock. And so I think things happen like that that become seared in your memory. You don’t wanna just shy away from an interesting business or an interesting group of people just because of some customer concentration. But I do think that, by and large, if you avoid companies that will not be able to take a punch, you’re much more likely to compound capital over time.
Meb: A really fun example, challenging too though because many of those cases, well the concentration risk is obvious and ahead of time but how a company will handle it, in some cases, it’s like the psychological damage not even at CEO level but like employees who were like, “Oh, my god, this company no longer has any future. I’m not getting a good bonus this year.” Moral just like goes out the door.
Ben: And then your sales go to…you know, new sales go to zero.
Meb: Yeah. And you lose people because they’re like whatever. This has no future, it’s tough. It can still be actually like a good business with bright prospects but the mood is changed. I mean you saw this so much in internet bubble aftermath and the last financial crisis, you know, so many companies that just never recovered. Even going back to the blog, like I go back and look at companies and links on things we used to write about that just no longer exist. And some of the reasons is obvious in retrospect but in many cases it’s hard. But concentration risk is a double-edged sword. Ask anyone who has exposure to China, like you mentioned earlier, or Amazon or anything else. It’s tough. Does that company still exist?
Ben: It does still exist.
Meb: Forty cents?
Ben: Yeah. It’s sub a dollar.
Meb: This could be Ben’s next step. He goes into the operating side of business, takes over the business, does a leverage buy out.
Ben: You know, I would sleep much better at night investing in a group of businesses that are getting more valuable every day run by people who understand capital allocation better than I do. And, you know, just let them compound.
Meb: The business side is so much work, so much work being operator, man. Entrepreneur, it never ends. Just daily assault from capitalists, seven billion capitalists around the world.
Ben: You run a business here, right? I mean it’s funny because like there’s so much…people think this is such a glamorous business and there are incredible aspects of being a money manager and I tap dance to work. I love what I do, I love researching companies. Maybe we start with a proxy statement, it’s an under-discussed item, and the other thing is the business of investment management. And people think that you spend all your time as an active manager on your stocks and it’s just not possible because you’re running a business, you’re running a portfolio, and you have really demanding customers. And then Buffett says, you know, he’s a better investor because he’s a business owner and vice versa.
And I think it is hard but I think it also makes you more appreciative of your partners in terms of company management teams and the board. Just because you’re sitting behind your desk reading their 10-K and thinking, “This is so easy. Why aren’t they doing this?” Well, because these are run by people and they have people…and they have mouths to feed, and they have employees that they don’t wanna fire. And so, it’s not…being involved in the business side makes you, I think, a little more empathetic, especially things aren’t going right in the companies you own.
Meb: Well, you mentioned earlier in the very beginning as you’re talking about Cove Street, I think people often will say this about the advantage of having a legit operational and philosophical structure to the company to where it runs on a certain professional level, that’s really important. And I joke that most people probably at the UCLA class think our world is more like Bobby Axelrod on “Billions” when it’s probably more like the opposite. I don’t know, I don’t know what show to compare it to but it’s not necessarily flying around on jets and hot trading stocks all day long and the excitement of being court-side at Knicks. Knicks may not be the best example, they’ve been in the toilet for 10 years.
Meb: Yeah, man. We’re gonna have some exciting home teams.
Ben: Yeah. We have a new team now basically.
Meb: Yeah. Soon to be sponsored by Cove Street Capital. I look forward to you guys getting some season tickets courtside, right?
Ben: Yeah, yeah.
Meb: The value investors will be in the upper-upper deck.
Ben: Yeah. Maybe when the next market downturn and people will remember why value investors and active investors still exist.
Meb: That’s funny. Man, this has been a blast. We’ll have to do this more often. Where do people go to find more information?
Ben: Yeah. So, we spend a lot of time curating our website and our blog, so covestreetcapital.com. If you go to our web blog, our thoughts tab, you’ll see there’s a fair amount of posting. I post a fair amount, it’s part of our job. Jeff Bronchick says that we’re gonna be fired if we don’t contribute to the blog because it’s called Cove Street Capital, it’s not called Bronchick Capital, it’s called Cove Street for a reason. I mean this business is set up to survive Jeff whenever he’s 97 and wants to retire. I could see him doing it longer than Munger. He wants all of us to have a voice so you’ll find a fair amount of content and videos and, you know, letters and stuff like that. So, I think if you’re interested in Cove Street, you can even…you know, remember us talking about our process and strategy, you can see that we’re not a black box. You can learn all about us just by clicking some of the links on our site.
Meb: Is Munger…he’s like 90, he’s not 95, is he?
Ben: I think he’s…
Meb: He is 90.
Ben: Yeah, he’s in his 90’s.
Meb: Incredible. Listeners, if you get a chance go to The Daily Journal meeting in L.A., let me know next time, I’ll join you. I’ve been once, have you ever been?
Ben: I have.
Meb: It’s great.
Ben: I have, he’s great in person. And if you’ve been to a Berkshire meeting, you feel like he’s a little bit restrained because of so many people. When you go to The Daily Journal, you get, you know…
Meb: You get full Munger.
Ben: …Full Munger, which is brilliant in a lot of ways.
Meb: We’ll add all the show note links. Ben, it’s been so much fun. Thanks for joining us.
Ben: Yeah, thank you. I really enjoyed it.
Meb: Listeners, we’ll post links to Cove Street, everything else good we chatted about today at mebfaber.com/podcast. You can send us any critiques, reviews, thoughts, suggestions, firstname.lastname@example.org. Subscribe to the show on iTunes, Radio Public, Breaker, anywhere good podcasts are sold. Thanks for listening, friends, and good investing.