The Right Questions

by Dean Pagonis | CSC Research Analyst

As the newest member of the Cove Street research team, I have generally been shielded from most ongoing client adventures. However, (for reasons that have always been clear to me!), I have been introduced to a number of visiting clients and consultants recently and there was a question that stood out in my mind: “What questions would you ask yourself if you were in my shoes?” Terrific question and here is what I would ask “other managers.”

Can I see your notes on a company?

Everyone sees our spreadsheets and decision process. They are both critical and important, but they are also both built off of the copious notes we take from a broad variety of primary source materials and interviews. If you looked at the notes on virtually all of our companies the first thing you will see are key takeaways on all of a company’s public filings including the often overlooked, but extremely important proxy statement. Equally importantly, you will read in-depth conversations with industry experts, former employees, suppliers, end users, and competitors. We keep a running list of contacts and we are not bashful about reaching out to them again as a company evolves overtime. In addition, you would observe notes from industry journals (our favorite being Lubes ‘n Grease) and conferences. Whenever possible we like to attend industry conferences that are heavy on industry players and light on investors. My colleague Eugene Robin just returned from Money 20/20 and we will all be attending the World Ag Expo in February. Needless to say we can barely contain our excitement!

Cove Street puts a heavy emphasis on evaluating management teams—it is one of your three investment pillars (business, value, people). Why are people so important to your process and how do you effectively evaluate management teams?

A company is ultimately a collection of people. Computers are unparalleled in their ability to crunch and to extrapolate statistical conclusions from data. However computers are still relatively terrible at gauging the character, intent, and the abilities of management teams. (When computers can do this it will already be too late for humanity and we will welcome our robot overlords.) We regard return on invested capital as the best single quantitative indicator of a manager’s past capital allocation ability, but in isolation it can be deceptive.

There is still no substitute for looking a person in the eye and, in conjunction with their incentive structure and past behavior, coming to a conclusion on their ability to effectively manage a company. There have without question been instances where a manager who looks great on paper immediately gives you the chills in person. That is usually not a good sign. We also steadfastly validate our thoughts on the management through conversations with ex-colleagues and competitors.

We would also argue that people in many ways change less than the future. Business cycles, technological change, regulatory change, and elections are all examples of wildly unpredictable future events. People, on the other hand, while not perfect, rarely get stupid overnight or wake up a newly discovered genius at capital allocation. Past performance of management is a much better bet on their future than economic indicators.

You claim to be good research analysts and dig deep. Really?

Ask for the CFO contacts at three holdings and call them up. Does the manager ask good questions? Are they focused on key drivers of long-term performance or stock jockeying the next quarter? Would you give them money?

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