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May 14 15

One More Look at Currency

by Cove Street Capital

by Ben Claremon | Research Analyst

As of the huge currency moves the world has witnessed over the last year or so, the topic of currency hedging has recently become very pertinent to both investors and companies who generate sales overseas. For anyone who has not been paying close attention to the how much the dollar has strengthened, here are a couple of eye-opening data points.

  • The Euro/US Dollar rate closed at 1.07 on April 20th 2015, down from 1.38 in April of 2014—a 22.4% decline
  • The Yen/US Dollar rate closed at .0084 on April 20th 2015, down from .0097 in April of 2014—a 15.5% decline

Aside from making it much more attractive for Americans to travel to Europe and Japan, such large currency moves have significant impacts on US-based companies that have substantial sales abroad. Specifically, it is not uncommon to see companies forecasting revenues to be down 20% or more in their European divisions. Unsurprisingly, the term “constant currency” is showing up much more in press releases and on conference calls. In other words, companies are trying to get people to focus on what sales would have been if the currency had not declined as dramatically.

What matters more to us is whether actually business is being lost to non-US competitors as a result from an immediate pricing improvement and we would argue that the answer is yes, as no human or machine can adjust effective pricing that quickly and for that large of a move.

The second and really more interesting thing is whether a US-based investor should hedge currency when he purchases a non-US security.  After all, we would consider ourselves relative geniuses on the company and the value, not per se the macro currency trade, so why not hedge out the currency and let our genius prevail unobstructed by pithy macro trends?  To help answer that, we turn to our quant friends at GMO for an answer (see attached PDF). The conclusion may surprise you and may cause you to think twice about the logic of investing in currency-hedged ETFs.

May 14 15

Summer Reading List

by Cove Street Capital

All the Light We Cannot See — Anthony Doerr

Churchill — Paul Johnson

Hitch-22: A Memoir — Christopher Hitchens

How Life Imitates Chess: Making the Right Moves, from the Board to the Boardroom — Gary Kasporov

The Limits of Strategy: Lessons in Leadership from the Computer Industry — Ernest Von Simson

Mr. Bones: Twenty Stories — Paul Theroux

My Brilliant Friend — Elena Ferrante

Old Masters and Young Geniuses: The Two Life Cycles of Artistic Creativity — David W. Galenson

On Such a Full Sea — Chang-rae Lee

So We Read On: How The Great Gatsby Came to Be and Why It Endures — Maureen Corrigan

Talent is Overrated — Geoff Colvin

 

 

May 14 15

Things That Make Sense to Us…

by Cove Street Capital

…That Were Written By Other Guys

May 14 15

Atul Gawande, Money Manager

by Cove Street Capital

I have no idea how this guy has a life when I merely glance at his bio—but that is not our concern. Substitute “money manager” instead of doctor and his commencement speech becomes worth thinking about. And his new book, Being Mortal, is a stupendously important book for anyone that is a certain age…or merely has parents.

May 4 15

CSC Strategy Letter | Number 20 | Don’t Bring a Knife To a Gun Fight

by Cove Street Capital

CLICK HERE to download Cove Street Capital’s May 2015 Strategy Letter Number 20, “Don’t Bring a Knife To a Gun Fight”

Apr 23 15

The Good News is We Are on the “Public” Side

by Cove Street Capital

Managing $163 billion is not easy. What this piece points out is:

  1. It’s generally right.
  2. “Private” or “Alternatives” are a good idea only when practiced in small size and in small distribution. What is clear is that “alternative” investing as practiced institutionally is neither.
  3. Public pension math is a problem. Focusing solely on the asset part of the equation leaves one susceptible to the problems NY—among many others—is facing. The sad fact is that the liability side is where the bigger money is and that solution is beyond our political pay grade.
Apr 23 15

This is a Great Response

by Cove Street Capital

“Logic and experience indicate that barring investments in a major, integral sector of the global economy would—especially for a large endowment reliant on sophisticated economic techniques, pooled funds, and broad diversification—come at a substantial cost,” wrote Harvard President Drew Faust last year, explaining the University’s refusal to join the divestment brigades.

“I also find a troubling inconsistency,” she added, “in the notion that, as an investor, we should boycott a whole class of companies at the same time that, as individuals and as a community, we are extensively relying on those companies products and services for so much of what we do every day.”

Apr 23 15

Confessions

by Cove Street Capital

I have been an on-again, off-again subscriber of the Journal of Applied Corporate Finance (and a predecessor) for more than 20 years. It is worth reabsorbing every few years because our ears get so full of the conventional, PR-driven crap that pours out of corporate America. Then you subscribe again, ask the management team in front of you to hold for a minute, run to the other room and throw this down and say “Don’t talk to me again until you have read this.” It’s a living.

 

Mar 30 15

Further Thoughts on the Merits of Buybacks

by Cove Street Capital

by Rohan Rangaraj | Research Analyst

One of the official Favorite Books in the Cove Street Capital Library is The Outsiders by William Thorndike, an in-depth study of eight of the last half-century’s greatest CEOs in terms of value creation. One trait they all shared was the propensity to go against conventional wisdom and buy back their company’s own stock when it was cheap.

The key here is cheap. We’ve noted on this blog before that many Boards and management teams don’t understand effective share repurchase, and with events of late we can’t help but revisit the topic. By now you’ve surely heard that everyone is buying back stock. Some say it’s great; others are worried because these buybacks coincide with a market near all-time highs. We would argue that both are correct, and point out that it depends entirely on the situation. For some reason, the discussion often seems to neglect the simple task of framing it properly: intelligent share repurchases can add tremendous value in the long run, while mindless, unintelligent repurchases with no regard for value can do just the opposite.

Recently, General Motors reached an agreement with a set of activist shareholders to spend $5 billion on share buybacks over the next two years. On the one hand, no shareholder is complaining about the near-term effect it had on GM’s stock. On the other hand, one can’t fault investors who express concern at the prospect of a company in an intensely cyclical industry having less cash to serve as a cushion when an inevitable downturn hits. From our standpoint, we think GM is cheap, that it will be purchasing its shares below intrinsic value, and it has plenty of cash to weather even something a little bit stronger than a garden variety recession.

On that note, we were irked to come across this drivel vomited out by no less than the Harvard Business Review. The money quote: “Taxpayers and workers should demand that open-market repurchases by all companies be banned.” Ugh. We didn’t know they were letting high school seniors write for HBR.

While we won’t dispute that a majority of repurchases are likely done for misguided reasons without any eye towards intrinsic value—like, say, buying back exactly enough to offset dilution every single year regardless of price—it’s sheer nonsense to discount the enormous advantage prudent buybacks can create for a company whose management uses them as an effective capital allocation lever over the long-term. Arguments suggesting that buybacks ignore the common worker are extraordinarily short-sighted—for instance, they ignore the glaring likelihood that a company trading under its intrinsic value for too long will more often than not be gobbled up by a larger competitor (or private equity buyer) who invariably proceeds to lay off half the company. So not only does intelligent share repurchase add tremendous value in the long run, it can also add tremendous stability for companies as well. We are optimistic that GM’s should do the same.

On that point, we would be remiss not to mention one buyback program of recent years that was at least somewhat off the mark—that of IBM. Warren Buffett, in his 2011 letter to shareholders, extolled IBM’s leverage-to-buyback strategy of the prior several years. He further expressed his hope that over the next five years, as the company plowed perhaps $50 billion into buybacks, the stock would languish so IBM could buy in more shares more cheaply, and as a result he’d own a greater proportional share of a wonderful business.

Hindsight is 20/20 of course, but unfortunately that letter top-ticked the stock. 3 years and $40 billion of buybacks later, it’s fair to question whether IBM would have been better served had they allocated some portion of those buybacks towards more aggressively building out the weaker areas of the business. Despite using massive buybacks to show continued increases in EPS in dogged pursuit of the prior CEO’s stated 2015 $20 EPS target, the stock indeed languished up until last fall, at which point it tumbled off a cliff as its relative underinvestment in cloud and data analytics finally caught up to it and IBM abandoned its pie-in-the-sky $20 goal.

This is not to knock Mr. Buffett for failing to forecast this (though several have argued it violated his “circle of competence” standard), but it brings up an important caveat when thinking about buybacks: is it better to be a larger shareholder of a declining business, or a smaller shareholder of a business which actually has solid prospects for the foreseeable future? Instead of buying back $40 billion of stock at an average price of $191—nearly 20% above today’s price—as IBM did over the past 3 years, it easily could have used its cash along with a slight amount of leverage and, as some analysts have suggested, purchased companies such as Salesforce.com or Workday. Just taking those as an example, the two would not have come cheaply—they’d have cost around $25-30 billion for $2.5 billion in sales (versus combined market caps today of $60 billion and sales of $6 billion, growing 36%)—but they would have immediately established IBM as an early-mover in precisely the area which it finds itself so far behind today: cloud services. Meanwhile, in part due to the company’s efforts coming so late, IBM is seeing such an acceleration of declines that one analyst notes they are “dwarfing IBM’s ability to capture new revenue opportunities as the market shifts.”

Now, investors (yours truly included) almost certainly would have slammed IBM for the lofty multiples it would’ve needed to pay to snap up those businesses. However—and here’s the rub—it’s not likely that it has been overwhelmingly cheap to attract the talent necessary to build out those systems internally. Additionally, it has taken much more time for them to attempt to build these capabilities internally, while the resulting organizational dysfunction has led to considerable reputational damage for IBM with its longstanding clients. Being an early mover can mean a lot more in this business than it does in, say, widget manufacturing. Further, given the near-existential threat these competitors have posed to IBM—something the company almost certainly must have suspected at the time—IBM may have been better off paying a fair premium to save the company.

In any event, the result of all this is that IBM has scaled back its buyback program to a decade-plus low after it finally abandoned its 2015 goal of $20 EPS. While the stock reacted swiftly and negatively to this retreat, we can’t help but think that the resulting freedom from the tether of using buybacks to hit that arbitrary-and-no-longer-relevant earnings target just might enable IBM to act more aggressively and someday regain its prior heights (opportunistic buybacks included, of course!).

In the meantime, there is no question IBM is facing a very real threat, one that may at least have been partially staved off by a different capital allocation strategy over the past several years. The larger point here is this: blind devotion to buybacks is not much better than blind disregard for them. Buyback decisions ought to be intelligent and opportunistic (i.e. based on intrinsic value), but should also remain in balance with the other capital needs of the business as an important part of generating outsized returns over the long-term.

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The opinions expressed herein are those of Cove Street Capital, LLC and are subject to change without notice. Past performance is not a guarantee or indicator of future results. Consider the investment objectives, risks and expenses before investing. The information in this presentation 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 the security discussed in this report is or will be profitable, or that recommendations we make in the future will be profitable or equal the performance of the security discussed in this presentation. The report is based on data obtained from sources believed to be reliable but is not guaranteed as being accurate and does not purport to be a complete summary of the available data.Recommendations for the past twelve months are available upon request. In addition to clients, partners and employees or their family members may have a position in security mentioned herein. Cove Street Capital, LLC is a registered investment advisor. More information about us is located in our ADV Part 2, which is available upon request.

Mar 30 15

Send Your Kids to Bowdoin?

by Cove Street Capital

CLICK HERE to download a recent speech by noted Soros “sidekick” Stanley Druckenmiller.