In this episode of The Acquirer’s Podcast Tobias chats with Ben Claremon, a Principal and Portfolio Manager at Cove Street Capital. Ben’s focus is on the SMID-Cap Universe, where he believes the best opportunities exist for investors. Ben provides some great insights into:
– How To Identify Buffett Style and Graham Style Stocks
– The SMID-Cap Universe Provides Greater Opportunities Over Large And Small Caps – Here’s Why
– The Proxy Statement Is A Gold-Mine To Tell You How People Are Compensated And How They’re Going To Act
– Successful Investors Need A Devil’s Advocate To Try To Kill Potential Investment Ideas
– When You Run Concentrated Portfolios, You Only Need A Couple Of New Ideas
– Before Buying A Stock Ask Yourself – “Would You Rather Own Tootsie Roll?”
– Investors Should Spend More Time Focusing On The Culture Of The Business Behind The Stock
– PEST Analysis Provides Investors With A Great Risk Assessment Measure
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Tobias Carlisle: All right, you ready?
Ben Claremon: I’m ready.
Tobias Carlisle: Let’s do it. Hi, I’m Tobias Carlisle, this is the Acquirers Podcast. My special guest today is value investor Ben Claremon of Cove Street Capital, he’s a principle and a portfolio manager there, we’re going to talk to them right after this.
Speaker 3: Tobias Carlisle is the founder and principle of Acquirers Funds, fore regulatory reasons he will not discuss any of the Acquirers Funds on this podcast. All opinions expressed by podcast participants are solely their own and do not reflect the opinions of Acquirers Funds of affiliates. For more information, visit acquirersfunds.com.
Tobias Carlisle: Hi Ben, how are you?
Ben Claremon: Doing well, Toby. How are you?
Tobias Carlisle: I’m very well, you’ve got a disclaimer that you have to read, so let’s do it right now at the front.
Ben Claremon: Yeah, I know, I promised my compliance person that I would read the following, the views expressed herein are those of myself and do not necessarily reflect the views of Cove Street Capital, or any of its employees. The information on this podcast should not be considered as a recommendation to buy or sell any particular security, and should not be considered as investment advice of any kind. You should not assume that any security discussed is or will be profitable.
Tobias Carlisle: So, basically what they’ve done there-
Ben Claremon: We can start.
Tobias Carlisle: They’re trying to make sure that you’re personally liable for any stock recommendations that you give in this podcast.
Ben Claremon: Yeah, well, you know, this is the world we live in and I do what I’m told to make sure that I don’t get in trouble.
Tobias Carlisle: So you and I have known each other for quite a while. I met you possibly even before you have started your MBA at UCLA, is that possible?
Ben Claremon: So it was probably during the MBA.
Tobias Carlisle: During the MBA.
Ben Claremon: Because I moved here in 2009 for the MBA, but yeah, that’s probably when we met so, it’s almost ten years now.
Tobias Carlisle: But I feel like I’ve known you because you wrote the Inoculated Investor blog, the fantastic Inoculated investor blog. When did that start, 2009, 10, something like that?
Ben Claremon: Yeah, so let’s start with the fact that I never really wanted to be a blogger, I always wanted to be a portfolio manager and an analyst and I wanted to work on the buy side. But, I started my career in 2007 and if any of you recall what had happened over the next two years was the financial crisis. And that was not an easy time to get a job and so I kind of bounced around on the buy side in New York City, and you know, I’m always looking for something to distinguish myself. And so I started the blog basically with a launch with the notes from the 2009 Berkshire meeting. I went to the meeting, and I had the crazy idea that I was going to take down every word that Buffett and Munger said. I will tell you, going back to 2009. I wrote this out, I didn’t even use a laptop, so, it was-
Tobias Carlisle: It was handwritten?
Ben Claremon: Handwritten, I think the first two were handwritten and then I got smart, I said, “This is ridiculous.” And so, that was it, its unique content, back then there weren’t that many people, that wasn’t transcribed over any internet platform. So really, all you had was people taking notes and posting their notes, and so that was kind of the genesis of the blog, I thought that would be differentiated content, I was just trying to stay in the game. Because I was transitioning to business school, wanted to stay as on the ground as possible in value investing and so that was a great platform for that and I met a lot of really interesting people like yourself. And it’s funny, people recognize me, they’re like, “Oh my god you’re Ben Claremon, the Inoculated Investor.” I’ll be at a conference or something like that, it’s funny and gratifying in a certain way. But these days I spend very little of my time writing and most of my time researching companies.
Tobias Carlisle: So I just want to tell everybody, the Inoculated Investor comes from that great Buffett quote where he says, “Value investing is like an inoculation, right? It takes or it doesn’t take.” So clearly, unfortunate both you and I have been infected and have suffered as a result over the last decade. But you’ve gone into Cove Street Capital, which you’re a principal there and a portfolio manager, and you guys run about a billion dollars based in Los Angeles. Tell us a little bit about the value strategy, because I always say, value’s a very broad church and it encompasses very deep value guys through to the franchise compounder guys like Buffett. So how do you characterize your style and how does that manifest?
Ben Claremon: Yeah that’s a great question, and I’ll even add another nuance there, it’s been different, value means different things to different people at this firm. We’re not even one uniform beast when it comes to how we look at value, but let me give you Cove Streets general philosophy and the way we approach value, and I’ll come in and put my own spin on it. Because as I’ve learned, and I’ve suffered in certain investments, I think my preferences have changed a bit. So, Cove Street, we look at value two ways, so what we call a Buffett stock and a Graham stock, and a Buffett stock is your traditional compounder, higher returns on invested capital, with a moat, and it’s a business that’s probably not training at a 20 cent dollar, 30 cent dollar. You’re probably playing an 80 cent, 90 cent dollar and you invest in it because the business is getting more valuable every day because the people who run the business understand capital allocation. And you benefit from the math of compounding and so you’re not getting it dirt cheap, but over time the value increases and that’s how you make a return.
Ben Claremon: So those are our Buffett stocks, and on the other hand, there are our Graham stocks, which are kind of an homage to Ben Graham who was a net investor. Not many of those these days, but when we’re talking about a Graham stock, we’re talking about a business that is, for some reason just not great. Whether it’s got cyclicality to it, or whether it’s got just a small total addressable market, or it’s got customer concentration, or end market concentration, that leads to cash flows that might not be particularly predictable or returns on invested capital that are just somewhat mediocre. And so, those businesses you want to buy cheap, you want to buy 50 cent dollars, you want to buy 60 cent dollars, and the difference in terms of our sell discipline, which we talk a lot about and think a lot about is before we buy a security, we pre-identify, is this a Buffett or a Graham? And if it’s a Buffett, and it gets to fair value, we’re more likely to hold it because we can benefit from the math of compounding and the business getting more value on the every day.
Ben Claremon: On the other hand, you have the Graham stocks, and what a Graham stock gets to fair value, we’re much more likely to sell it. We don’t want to fall in love with a business, we understand what it is, we understand what the risks are, and so once that margin of safety has been reduced, we’re much more likely to sell it. And so, our portfolio or our core small-cap portfolio is an eclectic mix of Buffetts and Grahams, and I would say we would prefer to own all Buffett businesses, in a perfect world we would own great business that are trading at 60 cents on the dollar and then we would go to the beach. But unfortunately, it’s a little harder than that, right? And so, Jeff Bronchick, our founder, he has a very eclectic view of value.
Ben Claremon: He will take an 80 cent Buffett or he’ll take a 60 cent Graham, we’re just very careful about position sizing and our sell discipline to make sure that we’re not assuming too much risk. On my evolution as an investor has really been colored by the number of times that I’ve seen businesses that either had mediocre people or just were mediocre in terms of their returns or their addressable markets. I feel like, if you just looked back at our history, the mistakes that we’ve made have been in lower quality businesses. And when you’ve been scarred enough times by investing in cigar butts and businesses that aren’t getting more valuable every day, for me personally it changed my philosophy.
Ben Claremon: So not to compare myself to Buffett at all, but in a sense, he made that progression, he studied with Ben Graham, and then he started to think about, “Hey, maybe I should invest in better businesses.” And so that’s kind of where I am, and so the portfolio that I co-manage Jeff, our founder, is a more Buffett oriented strategy. And I think these days I spend all of my time start with a good business, figure out who’s running it and whether these people are friend or foe and then focus on the value. And one other thing is create the Buffett list, which is the list of companies you’d like to own at a certain price and do the work, create model, have a price target and you know what the great thing about markets is that they’re … Well, they used to volatile. In theory, they’re volatile and vicissitudes of the market can create opportunities for us.
Ben Claremon: So do the work, be ready and have a list of companies that you’d like to own, and so that’s kind of the framework we’re operating under, and kind of bifurcated between Buffett’s and Grahams.
Tobias Carlisle: And your universe is quite clearly defined, I don’t think I’ve seen anybody as explicit about the universe that they look in. You guys are small to smid-cap, is that fair? Or small to mid-cap?
Ben Claremon: Yeah, smid. So, our small-cap strategy encompasses three billion and under, any securities three billion and under, and our smid-cap strategy, the one that I co-manage with our founder is a billion to 12 billion. So, I think basically we consider ourselves a small-cap firm, and so why would we do that is the question, right? I’ll put it out there, we’re not asset gatherers, we’re not looking to raise 20 billion dollars in large-cap value, because that’s a strategy that’s scalable, and you can raise a ton of money in it if you’re successful. It’s not in our heart, and we feel like it’s much harder to be differentiated in large-cap when you’re looking at Apple and Microsoft and Google, there are hundreds of analysts in the buy side and sell side looking at these things. And for us, we don’t feel like we can gain any kind of edge by the work we do, and so our general strategy and our process is to do a lot of work, and what does that mean?
Ben Claremon: I mean, I think everybody says that on their website, and I’m not disparaging everybody, but I think it varies depending on your process. And so our process, since we, and I’m going to get to the, “Why small-cap?” In a second. But since we do a lot of work, and our process is based around trying to determine, trying to figure out if we can get information to have an edge, and so, what are we doing? We’re going to trade shows, we’re calling customers, and competitors, and suppliers, we’re going to meet management. We’re going to poke around their office to see if they have fancy paintings and chandeliers or whether they’re kind of the true value and true Buffett like value investors. And they drive the same car that they’ve driven since the 70s, we’re really trying to understand the people and do a bunch of due diligence on the business.
Ben Claremon: And our sense is if you do that, and you’re successful at it, and you have a repeatable process, what you can do is, obviously we’re not talking about inside information. But you can have an understanding of the business and the people that a lot of people don’t have, and these are businesses that are often covered by one or two analysts, not 20 or 30. They may or may not have conference calls, I mean, we like things that are kind of off the beaten path. People who are not focused on short term wall street stuff, and not focused on quarterly earnings, and they’re really thinking three to five years out. Maybe even a family owned, a family-controlled company, someone who has what Tom Russo calls, “The willingness to suffer.” Right?
Ben Claremon: Someone who will invest for a long run at the expense of the short run, and so why small-cap is, in general, we think we can do that better in small-cap, and we can get some kind of informational edge and the academic research, I’ll let you … The guy who does the research thing about this, but I think for the part what we have is small-cap is an anomaly right? The thing that has for a long period of time outperformed.
Tobias Carlisle: I think you’re getting trolled there.
Ben Claremon: Yeah it’s okay, that’s our co-manager, that’s our dynamic.
Tobias Carlisle: That’s fantastic. You’ve got a really detailed interesting process in the document that you sent through. You’ve got this four, you describe it as a four-step process, can you take us through those steps and talk a little bit about that?
Ben Claremon: Yeah, happy to do that, again I think we pride ourselves on more than anything else, is on the process because you can’t control the outcome, but you can control the process. So we want to put ourselves in a position of having a good process and even if we have bad outcomes, at least we’ve covered our bases, and we want to understand the difference between good process, good outcome, and bad process, good outcomes. Because a bad process, good outcome is just luck, and we’re trying to as little as possible depend on luck. So we have a four stage process, which starts kind of in a screening, so everyone has some form of screening. We have Capital IQ populated screens that run every Saturday.
Ben Claremon: We run through them, and on Monday morning we come and talk about them, and so what are we screening for? We’re screening for good businesses trading at reasonable prices and we’re trading optically cheap businesses and so again, the Buffet and Graham paradigm. And so with traditional valuation metrics like enterprise value to Notepad and enterprise value to EBITDA plus it’s more like a Greenblatt screen, which is stolen from Joel Greenblatt, trying to figure out good businesses that are trading at reasonable multiples. And then we also just screen for behavioral changes. So a CEO change, someone mentions strategic alternatives on a conference call, some kind of evidence that there’s a movement at the company.
Ben Claremon: Because we think that a lot of money can be made or lost, depending on investing in inflection points, and so if you can determine an inflection point in the business, you have an opportunity to make a fair amount of money. So, there’s that, so that’s one element of our screening, the other thing is, we may not be the largest firm in Southern California, but we’re strategically located right by the airport, and what that means is that we get a lot of management meetings. The south side brokers bring a lot of people through here, we don’t spend a lot of time even thinking about what the sell side things, but we have relationships with these brokers and I think Cove Street’s a pretty good spot for management meetings because we ask thoughtful questions.
Ben Claremon: We’re not bothering them about quarterly earnings, we’re thinking three to five years out, so kind of with that long term focus often it’s refreshing to executives in a sad way. So the other thing we do is, we, at least we have, a fair amount of institutional knowledge. So everything we do and read and see gets captured in either OneNote or in a Word doc. And so what that builds, it’s like a fair amount of institutional capital of businesses that we’ve looked at in the past, and then Jeff, our founder, has been in the business for basically forever since the early 90s and so he’s got a fair amount of institutional knowledge. I’ve been in the game for almost ten years now, so we’re talking about a fair amount of institutions knowledge there.
Ben Claremon: So, really what it is, is that’s our screen process, and so people always ask us, “Where do ideas come from?” And you know what, we’ve looked back and we actually record this in our stage four of the process, and there’s no consistency, and I don’t know that’s a bad thing per se, right? Sometimes, someone comes into the office and it’s really interesting, sometimes it’s the company we followed three years but have never really done the work on but we found something was interesting. And sometimes we’re reading the Wall Street Journal and maybe not the main company that was mentioned in the article, but a sub-company. And then another thing is, we often like to, and you see this dynamic in small-cap versus our small-cap plus strategy, is that in small-cap we’ll own kind of the little brother of a larger cap company.
Ben Claremon: So we’ll own them both, but one’s a small-cap and one belongs in our smid strategy. So people always try to pin us down in terms of how we find ideas, let me just say it’s eclectic and we’re opportunistic. And since we run a concentrated portfolio of kind of 20 to 29 in smid, and 30 to 39 names in small-cap, we don’t need that many new ideas. And so our strategies are designed to be lower turn over, and so honestly if we can find two or three new ideas a year, I think that would be plenty. So, our process, and so I’m framing our process a little bit, our process is deep with the intention that we’re going to discard 9 out of 10 things that we look at, 19 out of 20 things we look at. So, that flows into stage two of our process, which is kind of our data download, what we’re trying to figure out is, what kind of business is this?
Ben Claremon: And this is what we call the verify stage, and so we’re trying to figure out, is this a Buffett or is this a Graham? Because what we’re trying to do is pre-determine our sell discipline. If it gets to fair value and it’s a Graham, we’re going to sell it, if it gets to fair value and it’s a Buffett, we’re more likely to hold it. And so this is where we have a Cap IQ populated spreadsheet that basically is just the template for a model, and so you plug in the ticker and all the historical information pops out. And what that does, is it allows us to try to determine what kind of business this is, and so that’s readings ks and qs, we spend a lot of time thinking about the proxy statement. More so than just about any other investors I ever talked to, we’re always scrutinizing that document to figure out what incentivizes people because the truth of the matter is, tell me how you’re compensated and I’ll tell you how you’re going to act.
Ben Claremon: And the proxy statement is a gold mine to tell you how people are compensated and how they’re going to act, and so we spend a lot of time evaluating that stuff. So let’s say after the first view, I’ve determined, or one of my colleagues has determined that this looks like a pretty good business, the people seem good to okay, and looks reasonably valued, right? Then we move into stage three, which is our team tackle, and so this is something that’s a little unique about Cove Street, and it’s an outcropping of the fact that we’re going to limit our asset size because we’re a small-cap focused firm. We’re going to limit the number of strategies that we have, and we have a limited number of securities because we run concentrated portfolios. So, what that means is that we can team tackle ideas, and so what a team tackle is, is that every idea has two longs on is and one short.
Ben Claremon: And the two longs are kind of focused on creating the Bull case, and when we move to stage three, we put this into our workflow. So it’s not like we drop everything, but we’ll have to recruit, so if I have an idea I like, I’ll recruit one of my colleagues, and he’ll be my co-long, and we’ll say, “Who wants to be the short?” And so what’s the point of the short? A short is the devil’s advocate, a short is the person who is coming up with reasons why we shouldn’t own it. The idea like, “How do you kill the idea?” And so what that does is it creates this back and forth dialogue about the risks and the benefits of this company. And so basically you have the whole team working on it, and what that does is, we benefit from the fact that we have different backgrounds and different thoughts processes.
Ben Claremon: So, I think Jeff created Cove Street in a way that he didn’t want all of us to be, and there’s nothing wrong with being this, but he didn’t want us all to be like ex-investment bankers who spent three years in banking, worked one year in private equity, and now are working on the buy side in equity research. Eugene Robin, my colleague worked ViaSat as a satellite programmer, I come from the real estate industry, my colleague Dean basically worked for a government agency, was like an outsource CIA kind of investigator. So really what it is, is taking all these peoples backgrounds, and all these different perspectives both on value and a focus on value investing, and meshing them together and coming up with a really, I think, good back and forth about this company, and so that’s stage three.
Ben Claremon: And so-
Tobias Carlisle: Just before you go into stage four, how often does a short prevail over the two longs and what are the sort of reasons why a short might prevail?
Ben Claremon: That’s a great question, and so I mean, by definition, the short prevails far more often than the opposite because we pass on so many things. And it doesn’t necessarily mean that the short had some kind of like, silver bullet moment where “We can’t own this because of this.” Like you found a fraudulent thing, it’s not that. It’s more like, you can convince your colleagues who are excited about it, that there are more risks than rewards, and that the symmetry isn’t there or maybe the value isn’t there. Or that, and this is something that [inaudible 00:21:52], or that the people are not people that you can trust. And so, I think what this does more than anything else is creates a culture where we’re both willing and able to accept criticism, where we’re willing and able to accept other peoples ideas, and we listen to each other. And I think that’s really hard to build, and I give Jeff a lot of credit for being able to kind of inoculate that culture.
Ben Claremon: But I would say, since we pass on 9 out of 10 things, 19 out of 20 things we look at, the shorts are often either very persuasive, or I think the most often is the case, is that we all get into our analyst room, and we kind of banter back and forth the lead analyst realizes that this is for whatever reason, whether it’s the value, whether it’s the business, whether it’s the people, it’s just not the right kind of investment for us. But the good thing that we do is that we make sure that we, and this goes into our stage four, we capture that decision, and we make sure that if it’s just about price, if we’re not willing to pay what the current price is, what price would we buy it at? So that all that work that we’ve done isn’t lost, and it’s recorded, and we put it on a watch list with a price target.
Ben Claremon: And if it hits that price target, then all of a sudden we can re-engage, and so all that information, all that back and forth is captured and not lost. And so I’ll move into our stage four, which is our decision process spreadsheet. So we don’t write 20 to 30-page investment memos, I know with some firms do that, we have a very flat organization. We all sit out together, we’re not locked in offices, if I want to talk to Jeff, or I want to talk to Eugene, or I want to talk to Dean, I can just stand up and talk to them. The information flow isn’t kind of gated by either having offices or having to speak on emails or being in different cities. We can iterate, and do more work and come back to each other very quickly, and so this is our final process.
Ben Claremon: So let’s say I’m the lead analyst on an idea, I like the idea, I want to bring it to a decision. So, we all get into the room, and we record our decision. So, we fill out our decision process spreadsheet, which is really just a checklist of many of the mistakes that Jeff made over his career encapsulated in a spreadsheet. And so we have a tab on the four key variables, so why four? There’s nothing magic about the number four, it’s just that Jeff and the way he created his firm, and I think it makes a lot of sense is that, he recognized that there are a million different variables that you could consider for a company. But really it’s going to come down to three to five really, really important things that are going to determine whether you make money.
Ben Claremon: We also have the short points, so the short writes down his kind of reputation of the long premise. We have soft thoughts, so they have to ask like, “What are we thinking the markets not thinking?” Because if all we can do is regurgitate what the markets thinking, we probably don’t have a differentiated perspective. What’s our downside if we’re wrong? So trying to capture, if we’re wrong, how bad could it possibly be? And where is this company in seven years is another question we ask. Not a quarter out, not three months out, not three years out, but seven years. Trying to take yourself out of all of the noise that surrounds companies in the short run mainly because of the quarterly earning cycle.
Ben Claremon: And then we have a question like, “Would you rather own Tootsie Roll?” And I don’t know if you know anything about Tootsie Rolls-
Tobias Carlisle: Of course.
Ben Claremon: The interesting thing about Tootsie Rolls is, it’s the easiest company in the world to understand, they sell candy, right? And they sold candy for a really long time, and the stock trade did an unbelievable multiple and it’s like, I don’t know, but it was a husband and wife team, it was just an incredible little business. But it’s really a question about simplicity, is this business really difficult to understand, are there a million moving parts, 20 different things that have to go right for you to make money, like wouldn’t you rather just own tootsie roll my you know what it is? And so, these are the things that we put on our spreadsheet, and the lead analyst fills it out, and then we all get in the room and then we discuss it.
Ben Claremon: And so, Jeff, in his infinite wisdom, wanted to make sure that he didn’t bias the process, and that we could create a process that mitigates the behavioral biases. So this is what you learn from being in the industry as long as I have, and managing other peoples money, is that you’re constantly bombarded with behavioral biases that creep in. I know for a fact that anchoring, which is kind of that you become anchored into a number, so if I thought we should be buying a stock at 30 and we didn’t and the stocks 35, I’m going to anchor to the 30 dollar number and it’s going to be very hard for me to move off of that.
Ben Claremon: And so I recognize some of my biases, and all of us have different biases. But our process is designed to try to mitigate some of that, and so that flows into our final decision process. So everybody who worked on the idea weighs in and records their preference, so why do we do that? One, because we don’t want the kind of he said, she said two years later, “I said we should have bought that stock.”. “No, you didn’t want to buy it.” Right? We write it down, we record it. And the other thing is, in terms of compensation, Jeff can figure out, as he’s thinking about compensating us, like who’s doing well, who’s giving good ideas. And then, if he’s not accepting our good ideas, then maybe he needs to rethink about his process.
Ben Claremon: And so, Jeff as the portfolio manager on our small-caps strategy always goes last, because he doesn’t want to bias us, because if your boss says, “Hey, we should buy this.” Well then, maybe you change your opinion. He wants to hear our unbiased opinions, and we go around the room, you know, “Ben, what do you think it’s worth, what are you thinking we should do? What position size, and if we aren’t going to do something now, is there a price that you’d buy it at?” And then we all go, and then Jeff weighs in on the final decision. The only difference between a small-cap and the strategy that Jeff and I run is that Jeff and I are the final decision makers in our smid strategy.
Ben Claremon: But, I’ve given you the 30 thousand foot overview of our process, I think it’s very comprehensive, it’s designed to unearth interesting information about companies and it’s also designed to make sure that we are not falling subject to any number of behavioral biases.
Tobias Carlisle: It sounds like a great process, and it sounds like you guys have created a great culture there, and I noticed when I was going through your slide deck that one of the things you look at in the firms that you’re examining, in the stocks that you’re examining, you spend a lot of time on the culture. And I thought that was an usual slide, and particular detailed, can you just expand a little bit more on what you’re looking for in terms of culture in the stocks that you’re looking at?
Ben Claremon: Yeah, so I don’t want to get on a soapbox, but I’m going to spend a second on it, to some extent the idea of shareholder value, is that shareholders be more valuable than all the other stakeholders has captured corporate America, right? And I think that leaves a lot to be desired in the sense that, there are plenty of other stakeholders in a business, whether it’s your employees, or suppliers, the environment, the board of directors, there are plenty of other stakeholders involved here. And if you’re only focusing on shareholder value, I think you miss out, and you potentially cut off your own legs in terms of the ability to perform over the long run.
Ben Claremon: So, we’re really focused on finding people who are thinking long term, who are acting long term, there are red flags that come up that we try to stay away from. So if someone who’s constantly restructuring, which means that you’re always firing people, you’re probably impacting the culture negatively if people don’t know whether they have a job anymore and they’re always worried about being fired. These are things that are problematic, and so we have a list that we go through when we’re assessing management. So when I think of culture, our whole assessment of management embodies within that idea of culture. And so maybe to make it more concrete, I’ll give you some things that we are looking for and things that we are not looking for.
Ben Claremon: And so let’s start with what we are not looking for, so, we are not looking for companies that when you go through their financial statements they have a laundry list of environmental liabilities or legal liabilities. These are things that might be indicative of a culture that might be a little bit too aggressive in certain ways, we’re certainly not looking for people who are focused on the short run in any way, shape, or form. So whether that’s focused on making quarterly numbers, whether that’s going to the proxy statement and seeing that they’re focused solely on kind of short term results, or primarily on short term results.
Ben Claremon: We also want people who are focused on things that we care about, which is free cash flows and returns on invested capitals, and not quarterly earnings per share. Because again, incentives are a huge determinant in terms of how people act. And so, if I have to encapsulate it, long term focus people who are creating cultures that can last, and a lot of that can be reflected, and this is something else we do, we look at Glassdoor and Indeed.com to see how people are rated, right? And we track that over time just to make sure, or if it’s improving that’s good, but just to make sure in the companies we own that it’s not getting worse. I actually did a presentation at UCLA on assessing management in the proxy statement.
Ben Claremon: And one of my messages to the students, to the undergrads, was that it’s just really hard, it’s not quantitative, I mean, there are quantitative metrics, but it’s really qualitative, it’s a little bit squishy, but it’s doesn’t mean you could ignore it, right? Just because it’s hard to quantify doesn’t mean you can ignore it, and so what we try to do is we try to create a list of things we’re not looking for, try to create a list of things we are looking for, and have a checklist of those things. So, people who are focused on long term are willing to sacrifice short term results for long term gains. People who have a culture where when someone fails, they don’t get fired, it’s a learning moment, an organization that supports its employees, is willing to pay a living wage. I just think there’s a balance between short term profitability and kind of longevity that is, in a lot of cases, skewed way too much towards short term profitability.
Ben Claremon: And we’re looking for businesses who are thinking the long term, “How do we make this business sustainable? How do we make sure that we’re still around in 20 years?” And I just think businesses like that will be able to adapt much faster than someone who is focused on what they’re going to earn next quarter.
Tobias Carlisle: That’s fascinating, one of the things I noticed as I was going through your deck was this a PEST analysis, a P-E-S-T analyze, I’ve never encountered that before, I’m embarrassed to say but I did look it up before we talked. So can you tell us, what is a PEST analysis and how do you apply it?
Ben Claremon: Yeah, so we’re not macro investors, we don’t pretend to be macro investors, but we recognize that if you completely ignore the macro, you have a risk of being just totally kind of blindsided by some events that you weren’t considering. So, PEST is something that we fill out on our decision process spreadsheet, there’s a tab called PEST, and it stands for Political Economic Technological, and Social and so what are those? Those are political, economic, technological and social trends that can either benefit or hurt the company. So I’ll just give you some examples, so we were looking at an animal health company recently, and on the political side, there’s been a fair amount of regulatory things going on with feeding antibiotics to animals.
Ben Claremon: So, making sure that you are identifying that there’s a risk of further regulatory reform, more regulatory scrutiny, that would fall into political. Economic is kind of your normal, how economically sensitive is this business, does it follow the business cycles, does it have some kind of anti-fragile elements to it, does it have some kind of cyclicality to it, that’s the economic side. Social is, continuing the animal health idea, is like okay so if people are eating less meat because they’re eating impossible burgers, well that’s a social trend that maybe could impact this company or people have moved away from specifically poultry, moved away from having antibiotics in poultry and that’s been a social thing, it’s been less government mandate, it’s been more of a social thing.
Ben Claremon: So that has been an interesting dynamic for certain companies, and so which way are the social winds blowing is something that I think you can’t ignore, especially if it’s a consumer product of some kind. And then technological is like, what is the opportunity for technological disruption? If you are selling furniture online, I think there’s a fair amount of risk of technological disruption in that and new entrance, but if you’re selling aggregates for example, like you have a quarry, very hard to disintermediate that, there’s no app that can help you build a road, right? You need the aggregates, and so we’re trying to determined, how much risk is this company to technological change?
Ben Claremon: And so, the PEST analysis is just another risk assessment measure, and so we’re trying to figure out in everything we do, we’re really trying to figure out why not to own this company, and I know that might sound a little strange, but we’re looking for reasons not to own it. And if the overwhelming evidence is that the PEST analysis is a big threat, there’s two ways to look at it. One, you just shouldn’t own it, or one you should require an enormous margin of safety in order to feel comfortable with all of these risks. And so, we know that we’re not going to predict the direction of interest rates, or oil prices, but at least we can acknowledge the risk associated with the companies that we invest in.
Tobias Carlisle: How do you think about sizing positions, so you describe yourselves as concentrated, you said you’re running between 20 and 29 positions, how do you think about sizing them at inception, do you trim as they go up? Do you add as they get down, how do you handle that process?
Ben Claremon: Yeah, the ultimate question, and so it’s very difficult, these are the things that as you run money, you realize how difficult these things are in practice versus watching other people do them. But, in small-cap plus we have three position sizes, 2.5, 5, and 7.5. And in small-cap we have 2.5 and 5, and those are at entry, I think you want to have discretion as an investor but you also want to pin yourself in at sometimes so that you don’t have just what a consultant would call a dispersion. Where you don’t have like 1% positions here and 2.5% here, we try to keep it tight, and it helps frame the investment as well.
Ben Claremon: It’s not just a way to make sure that we don’t have accounts that are all over the place, it’s more about, “Is this the best idea or is this a half position which would be a good idea but maybe our best ideas?” And so, those are our position sizes to start, and as you can recognize, those are pretty concentrated position sizes, and I think the trimming and adding thing, there’s no universal answer to that. It’s, “Tell me about the security, what kind of business is it?” So, we want to buy businesses that we’re excited when they go down because we can buy more, and so in a Graham, if stock goes down 20%, I think you’re less likely to add to it, if it’s a Buffett, I think you’re more likely to add to it.
Ben Claremon: So I think we are opportunistic in terms of adding and trimming, and it goes the other way like is a Graham starts depreciating towards fair value, we may sell it all or sell a piece of it, or sell it back down to a 2.5% position. But if it’s a Buffett, you may be less inclined to sell it. So again it gets back to like everything we do kind of stems from this identification of what this business is, what this security is, is it a Buffett or is a Graham, and that will kind of tell us what to do when it’s up, what to do when it’s down, what to do when it gets to fair value.
Tobias Carlisle: Do you have a limit to the number, say you size something to 7.5%, so that’s very high conviction, and then it goes against you materially and if you still like the position, you like it more now because it’s cheaper, it’s at a bigger discount, would you be prepared to buy more in that instance?
Ben Claremon: Yeah, I mean I think you have to, and I’ve talked to a lot of my friends who run portfolios about this, and some people have rules about, “I’m only going to average down once or twice.” Or, “I don’t average down and we just let it ride.” I think everyone has different philosophies, I don’t think there’s any one right philosophy, it’s just about being right, right? It’s just about picking the right security, and not buying the one that goes down more and buying the one that turns around. But I think we’re always re-underwriting our ideas, and so if nothing is changed except for the fact that the market has determined that it’s worth 20% less than it was three weeks ago, I think we’re inclined to add to it.
Ben Claremon: And then at certain times, circumstance change right? Businesses change much more slowly than do stock prices, but it is true that businesses change over time. And so things that we had a fair amount of conviction in the past, we may not have as much conviction in the future, so those you’d be less likely to average down. And the truth of the matter is, if I was being intellectually honest if I’m not willing to buy it here, maybe we shouldn’t own it at all, right? And so maybe it triggers a reassessment or re-underwriting or a decision process node where we all weigh in on whether we should own this thing at all. I mean, I guess everything is about the Buffett rules right?
Ben Claremon: First rules is don’t lose money, second rule is don’t forget the first, right? And so once something becomes a security in which we see a risk of permanent capital impairment, that can trigger … I guess that’s kind of the answer to the question, is the security being down evidence of a risk of permanent capital impairment, or just the volatility of the market? It’s the latter that we want to take advantage of.
Tobias Carlisle: You are I were at a conference recently and we were chatting about small and mid-cap, and out of that you sent me a paper by Jeffreys talking about the opportunities in smid-cap. There are a couple of interesting facts in that, that really stuck in my mind, one is that of the Russell Indices since 1979, that smid-cap index is the best performed over that entire period. And one of the arguments that they make is that mid-cap gives you the returns of small with bat 15% less risk, presumably they’re defining that as volatility in that instance. But what’s the attraction for you in particular of that small to mid-cap range?
Ben Claremon: So, you’re preaching to the choir, I mean, I sent you that because I thought it validated our strategy. But the data’s interesting, and so let me give you the philosophy and then I can give you some anecdotes that I think will kind of crystallize why not necessarily our smid strategy, but any smid strategy can be interesting. Well maybe I’ll start with some anecdotes about Cove Street and they’ll kind of guide us to why we even started these strategies. One, so small-cap, the problem, I love small-cap and it’s evergreen because there’s just so many companies out there and there’s always a great opportunity in a few names, right? But the issue with small-cap is that your Buffett’s eventually leave small-cap.
Ben Claremon: And so we found ourselves at Cove Street, having to sell our Buffett stocks out of small-cap because at certain point if your entry point is three billion and under, and it’s an eight billion dollar company, it’s doesn’t make any sense to be in small-cap anymore, right? And so that was one thing that we saw, and the other thing that I saw is that, and I’m not trying to disparage anybody, this is just a personal anecdote is that, there are just the quality of everything surrounding the company, the management, the business, the end markets, you just find much better, more robust businesses in the four billion plus range. And so, it kind of gets to the idea that the Jeffrey’s piece discussed, which is you get a similar return, maybe a little bit less, but in this case, smid’s done better, but you may be a little bit less return, but there’s just less risk.
Ben Claremon: Because you have large total addressable markets, you don’t have as much customer concentration, you don’t have as much end market risk because you have diversification. And then maybe you have an international operation, so just having spent time in the sub-500 million market cap range, what you find is that these are just … You know, I joke, and I don’t actually mean this, but sometimes small-cap is like adverse selection. If it’s a small-cap, there’s a reason it’s a small-cap, maybe that’s because the total addressable market’s not that big, or management never had the bandwidth to go international. Or just the return structure, it can compound at a fast rate to be able to kind of get escape velocity and kind of create a business that can kind of get into the smid-market cap range.
Ben Claremon: And so, this is the way I put it to people, is that so if on one hand, on one end of the spectrum you have a manager who runs sub-Saharan African private equity, and on the other hand you have large-cap US value, I think that basically captures total inefficiency on one hand to relative efficiency on the other hand. I personally think that smid, even as you get about four or five billion in market cap, I think you’re much closer to the inefficient side. And so while you give up a little bit of that inefficiency that’s available in small-cap, I think you get it back in spades with quality of business quality of processes, quality of management, and these are just more robust business.
Ben Claremon: And then I’ll get to one more point here, is that what we’ve seen in areas where I said, I said we’ve made mistakes in business that just were kind of smaller and had maybe more impactful variables that could be materially negative, is that smaller businesses just cannot take punch, right? If they’re punched it can create a spiral, and whatever it is they become levered and they have to borrow from aggressive lenders and then they don’t generate cash anymore because interests rates, the spiral can really, really occur. On the flip side, if a four or five billion dollar business has one end market or one segment that’s underperforming, there’s a ballast, there’s a robustness that allows it to survive.
Ben Claremon: And so I think the data suggests what we saw anecdotally, and as I spend more and more time in this space I’ve felt the same thing, I feel like there are businesses that we can invest in that have all of the attributes of a Buffett stock, that aren’t household names, that are covered by 80 analysts, that have the ability to compound but they’re somewhat underappreciated. And so we’re always looking for stocks that are underloved, underappreciated, and underfollowed. And it’s been surprising to me the number of those you could find in the smid-cap range.
Tobias Carlisle: Yeah I couldn’t agree more, it’s my favorite universe, or it’s the universe that I use, on the low side I think I look at about, I think the smallest is 2.5 billion, but the average is around 4 or 5. I don’t have an upper limit, but just by virtue of the fact that I’m looking for very cheap companies, they tend to be down at that end, closer to the low end of the range. and this sounds slightly contradictory because I do agree with you that they tend to be underfollowed because all of the analysts in the bigger firms want big, liquid companies, so that pushes them into the large-cap stocks. But I think it’s where you find the professional private equity and professional activists, they sort of hunt in that 5 to 10 to 15 billion dollar range. Which is great if you’re buying a little bit cheaper than that, hopefully, they’re paying the take over premium to take you out, or they’re creating the activist campaign to sort of generate some returns for you.
Tobias Carlisle: So you see that in your stocks, do you find any activists or private equity targeting them you after you’ve bought them?
Ben Claremon: I think the simple answer is there are a lot of micro-cap and small-cap activists who unfortunately have like one remedy, buy back stock, right? Or sell yourself, there’s just two things, I think you’re right that as you get bigger you get into a much more sophisticated governance and shareholder-friendly advice from people. But I think even more interesting is about this space, and we haven’t actually seen this as much as I would have thought in our smid-cap strategy. But these are digestible deals, so it’s not that no one’s going to buy Cisco, it’s just not possible. But, a four or five billion dollar company is a digestible deal for either private equity as you said or from a strategics perspective. So, it’s like they’re not so small that they’re under the radar for the big PEIs and the big strategics.
Ben Claremon: But they’re also not so large that they can’t be bought, so I look at smid a little bit like a Goldilocks space, and when you have good businesses within that, that are getting more valuable every day, I think it always makes sense for either a financial buyer or a strategic buyer to be looking at these businesses, and I think I just want to be clear about our process, we certainly do not start an investment with the idea that “This is going to be bought.” What we’re starting our investment is, “This is a good business that’s getting more value every day, it’s run by people who understand capital allocation, it’s trading at a reasonable discount to our conservative assessment of intrinsic value, and someone else may recognize that and accelerate our return.” And in some cases, you’re sad about that because they take a compounder from you.
Ben Claremon: So, as a firm that’s built for the long run, and focuses on the long run, sometimes immediate gratification is not what you’re looking for. But our sense is if you combine the business value and people characteristics that I’m talking about, other individuals will recognize it as well and hopefully at least push you towards success.
Tobias Carlisle: When you step back a little bit and think about value as, it’s not an asset class, but value as a strategy, it’s been a difficult time for value, I’m not necessarily talking about your returns, I don’t know what they are, but it’s been a difficult run for value starting a year or so after the recovery in 2009. To date, do you feel positive about the future for value, do you think that we’ve got some time to go until we sort of shake everybody out?
Ben Claremon: So, I mean, this is the impossible question to answer, is value had been identified as an anomaly in academic research forever, right? And it worked for a really long time and the last ten years have been miserable for value investors. Especially on a relative basis, and so I think we fundamentally still believe in mean reversion, nothing has changed about that, right? Nothing grows to the sky and nothing continues to the fall to the center of the earth, and so in some ways, we will eventually see some mean reversion. But if you just think about what people are excited about in the world today, for the most part, it’s not the businesses we own.
Ben Claremon: And I think I wasn’t investing in the 2002 period, but I actually looked at the numbers recently and I thought this was interesting, is that I think it was, whether it was in 2000 or 2001, the market overall was down, the growth was down, but value was up. And so it was like there was this weird bifurcation in the market where it was really the high fliers, all those businesses that we joke about now that are not around anymore. Those were the ones driving the growth side and people, and when that turned around it turned around very quickly in terms of those stocks. But the value stocks outperformed and they outperformed by a large margin.
Ben Claremon: And you know, there are plenty of whatever those articles about Buffett being dead and value being dead and all those things. So we can’t spend that much time worrying about that, I mean, I will say from a firm perspective, yeah it’s been really difficult to convince a bunch of institutional investors that value’s the place to be. Because the truth of the matter is, even if they are long term looking, if values underperformed for 10 years, very few people have that long a time horizon. So, we can’t focus that much on it, and what I love about our strategies is that it almost doesn’t matter, I don’t want to be flippant about it, but it doesn’t matter to a huge degree whether the market is expensive or not.
Ben Claremon: Because I think overall, we fell like the market’s relatively expensive, it’s hard to find really interesting values, but when you run concentrated portfolios, you only need a couple new ideas. And market inefficiency is as such that you’re going to find opportunities over time. If you do the work and be pre-prepared for ideas to fall into your lap, and so that’s what we do. And it would be very nice if at some point there’s some mean reversion in terms of the value versus growth paradigm. But, we’re not counting on it, we don’t bank on it, we spend every day looking at securities from a bottom-up perspective. And that’s all you can do, aside from lament with people like you about the lack of opportunities or the poor relative performance of value.
Ben Claremon: It’s kind of like, you take it for what it’s worth and you try to find the interesting ideas, irrespective.
Tobias Carlisle: I couldn’t agree with you more, but it’s a funny point in the market where we both know that we can look at the historical returns to well-known value investors. You can look at the historical returns to the value anomaly, and it has typically outperformed. But, over the last 30 years, it’s really only had a brief period of outperformance in the mid-2000s and late 1990s was very, very tough as Buffett lost magazine territory. And then the early 200s to about 2007 really did massively outperform, and that’s that idiosyncratic return path of value where the market was getting crushed, but just being a long-only value investor generated returns. And then we’ve gone into a new regime again over the last 10 years where value really just can’t get out of its own way and the flows and the performance seem to have gone into the growth stocks.
Tobias Carlisle: But really, we’re at this funny point now, still where the value stocks, the value decile, that value anomaly, they’re still not that cheap, they’re at a slight premium to their long-run average. But the growth stocks are in nose bleed territory which is like a late 1990s, early 2000s type. So I have no idea what happens, but I do think that that gap has to close at some stage, and I do think that that’s beneficial for value. But I don’t know, and I’m sort of more hoping than believing.
Ben Claremon: Yeah, you have to be able to keep your clients long enough to realize whenever that mean reversion comes, right? What else can you do? I mean, these are things that, again we focus on process and not outcome, and if you have a good process and if you’re identifying good securities, we believe that the market will eventually recognize what we see in these businesses and then that’s the only way we can really outperform over time.
Tobias Carlisle: It’s been wonderful chatting to you, Ben. If somebody wants to get in contact with you, what’s the best way to go about doing that?
Ben Claremon: Yeah, so covestreetcapital.com, you can see our profiles, and I think my email address is on there, but firstname.lastname@example.org, happy to chat more about Cove Street, our process, our philosophy, talk about our culture because we didn’t talk that much about culture in terms of like what we’ve created here. But we’re a quirky group, I think in a good way, so I’m happy to chat about that as well, and happy to follow up on any of the things we talked about.
Tobias Carlisle: Very much appreciate you sharing the process and the philosophy that you guys use, Ben Claremon, thank you very much.
Ben Claremon: Thanks a lot, I really enjoyed it.
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