Successful Investors Need A Devil’s Advocate To Try To Kill Potential Investment Ideas

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During his recent interview with Tobias, Ben Claremon, a Principal and Portfolio Manager at Cove Street Capital provided some great insights into why successful investors need a devil’s advocate to try to kill potential investment ideas. Here’s an excerpt from the interview:

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 [Jeffrey Bronchick] 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, 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.

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