Properly speaking, there are only three reasons why someone should allocate capital to a money manager:
1. New funding or capital inflows.
2. An existing partner whose strategy makes intellectual sense has developed legitimate “people problems”—as in defection, death or dismemberment, merger hiccups, or acts of moral turpitude. You need someone else to fill the roll.
3. The area in which a manager operates has become painfully undervalued and the manager for the first time in as long as you can remember, is asking for money.
We think we have entered Scenario 3. This is one of those briefly awful periods which we secretly hope for when things are good and ideas are scarce, but that cause sleep patterns and cocktail consumption to change when they actually happen.
The obvious question is: why now? First, on a bottom up basis, we unequivocally have a lot to do. We own 32 stocks as we write and we want to buy more of (most of) them at the current valuation, which is not always the case. Our portfolio trades at the largest discount to our estimate of intrinsic value since 2011. Our new idea list is bulging with companies that fit into both the Graham and the Buffett buckets. Specifically, it is the latter group that really has our attention as we are buying really good businesses with good balance sheets. In fact, we arguably want the stocks to continue to go down so we can buy more. (Which is where you come in.)
The second issue is that many market “observers” seem to be oblivious to the fact that small cap stocks—as measured by the Russell 2000—have essentially been getting walloped for over a year and the value portion of the Russell has gone nowhere but down since June of 2014. It is equally important to note that equities outside of the Russell indices have performed even worse as they were not buoyed by ETF and index flows and thus conceptually represent even greater opportunities.
The bigger global issues are somewhat self-evident and are well covered by the Wall Street Journal and CNBC. While we are not ignoring the daily drumbeat of less than rosy news, in our opinion the issues du jour are inherently mean reverting and thus are buyable. For example:
• The global economy is generally weak. A buyable event.
• The dollar has sucked the life out of the profitability of large companies and smaller companies that sell into their supply chain. Currency issues are a mostly buyable event and one could argue that in a strong dollar, weak emerging market world, small domestically-focused companies are relatively more attractive.
• Short-term index flows out of equities. A buyable event.
• Small cap stocks have been the least favored asset class as determined by the world’s smartest men since 2009. (See Grantham and JP Morgan et al.) That call has been mostly wrong, but became pretty much right as far as expected return as the Russell 2000 became distorted in 2014 and 2015 with the explosion in “nonsense stocks” in bio-tech and social media. We are seeing that problem reverse itself daily and can sniff a glimmer of possible asset flows into the space as this continues. A buyable event.
As of this writing early in February, 77% of the Russell 2000 is down more than 20% and 44% is down more than 40%. THIS is precisely when you get a chance to buy small caps (and large caps that have suddenly become small caps) and the severity of the price decline has eliminated some of the blurriness of the line between being early and being wrong. When the Wall Street Journal declares a bear market in a specific asset class or when the National Bureau of Economic Research declares a recession, those are buyable events—not when visibility improves and we are seeing green shoots.
Let’s be clear. The only people who call bottoms consistently are liars or criminals. But valuations in what we think we understand and the anxiety we see around us (and occasionally in us) suggest leaning in.
This is without a doubt the most promotional statement Cove Street Capital has made since its inception in 2011. We are a firm that does not use the word “marketing” or “product” in any of its literature. There currently is an enormous opportunity to invest in small cap and we enhance that opportunity with thorough research and careful security selection.
