Written by Dean Pagonis

Mistakes are a key part of life. People who develop wisdom make a large number of mistakes, but they mitigate the impact of and learn important lessons from each mistake. Unfortunately, due to a number of recurring behavioral biases, most people don’t learn from their mistakes and are doomed to repeat them, often with disastrous results. The investment community is a microcosm of broader society. The vast majority of the “market” will repeat the same mistakes, but good investors learn from them. The key to learning from a mistake is to first identify that a mistake has been made and its root cause. Accordingly, we have compiled a non-exhaustive list of mistakes we have made in the past, each of which is broken out around business, value, and people — the three pillars of our investment process. When making investment decisions we consciously try to avoid the below mistakes, most of which are incorporated into our decision process framework.

Business Mistakes

Financials can go a long way in demonstrating the strengths or weakness of a business, but in isolation, they are insufficient because they are inherently backward looking. A newspaper business in the mid-nineties had astronomical returns, steady cash flows, and increasing sales. Looking exclusively at the financials would have caused one to conclude that these were fantastic businesses and they were, for the time being. However, fast forward ten years and you know the result. At Cove Street, we spend a significant part of every day assessing the merits of a business based on a number of qualitative aspects, all of which are geared to avoiding the below mistakes but none of which are immediately discernible in the financials.

One of the critical qualitative questions we are always trying to answer is whether or not a company has a cyclical or secular issue. Cyclical issues are typically buyable, secular issues are not. All companies have pressures that will eventually weigh on returns, but we try to avoid any investment where there is the risk of competitive or technological disruption in the medium term that will fundamentally impair the underlying business.

Unlike secular issues, which can sometimes be difficult to assess, binary customer, supplier, product, or regulatory risks are usually easily identified. Binary customer risk exists where a single customer represents a significant percentage (arbitrarily 10% or more) of a company’s revenue. Although companies will often claim to be able to pivot, in our experience it is often more difficult to replace large customers than management initially anticipates. Regulatory risks—outside of the medical field—are not as readily identifiable, but can serve the same functional purpose of destroying a business model. A government agency’s ability to block a critical asset sale or merger can be equally destructive. As a result of the foregoing, we stringently avoid companies with binary risks.

There is an entire group of mistakes that we should never make, what we have termed “research failures.” Every business we look at comes down to 3-4 key variables. If we get those variables right, our investment is likely to succeed. We work hard to ensure that we don’t miss a key variable. If a business or its accounting is too hard to understand within a few hours, it probably isn’t worth doing more work on. Our ability to identify the key variables become inherently impaired. In certain cases where the complexity is manageable, it is possible for one to assume he knows something the market doesn’t—specifically that he has an informational edge. Although markets are not perfectly efficient, they aren’t by and large stupid either. While there are certain outlier situations, in most cases when a company looks like it is terribly mispriced based on a perceived information advantage, the odds are that in fact you are the patsy at the market poker table.

The opposite of research failures are unknowable unknowns. The world is a big place and there can be value destructive issues that arise and are impossible to predict. The mistake in unknowable unknowns arises not from missing out on the variable in question, but rather from not attempting to incorporate this new information and not being humble enough to sell if the unknown destroys the original investment premise.

With that background, here is a brief list of the risks we face and attempt to mitigate as we make decisions under uncertainty:

• Secular
o Thinking a secular problem is really a cyclical one
o Underestimating secular headwinds
• PEST (Political, Economic, Social, or Technological issues)
o Technological or regulatory disruption was faster than expected
• Cyclical
o Buying a cyclical at the wrong point in the cycle
• Customer
o Binary customer or regulatory risk
o One product companies
• Turnaround
o Assuming a firm can elevate margins to its competitors’ levels when it cannot
o Company under spent on capex/R&D
• Costs and commodities
o Commodity prices are the key variable irrespective of management
o Rapid input price inflation destroys margins
• Research failure
o Underlying business dynamics are too complex
o Assuming you know/weight something the market doesn’t
o Failing to identify a key variable
• Unknowable unknowns
o Unforeseen competitor that disrupts the industry, for example the “Apple Watch”
o A juggernaut such as Amazon enters the market
o All “real option” value is actually negative or a source of cash burn

People Mistakes

We often debate the merits of having a business so good that a monkey can run it, but until Bubbles is given a CEO title, we remain focused on properly assessing human managers. Every company is a collection of people operating within a given incentive structure and opportunity set. A poor management team can ruin the best business in the world and conversely a great management team can dramatically improve an extremely weak starting hand. Cove Street therefore spends a significant amount of time getting to know management and the company culture. Furthermore, we very carefully digest companies’ proxy statements to ensure that compensation structures are closely aligned with shareholder value creation.

Some of the mistakes listed below are structural and can be identified quickly via the proxy statement. For example, dual share class voting structures, board composition/structure, and incentives are all listed in the proxy for everyone to see. B shares with disproportionate voting rights are not in themselves a guarantee of future mistakes. There are some B shareholder structures that have generated massive returns (such as John Malone’s Liberty Media entities) for shareholders, but a B structure can allow a poor management team or board to enrich themselves at shareholders’ expense and or even drive companies into the ground. Board structure requires a similar degree of nuance. A board with annual elections is preferable to a staggered board as it promotes greater shareholder accountability. But, the presence of staggered board is not necessarily correlated to poor stock performance. Egregious compensation practices that incentivize sales or EBITDA growth—especially via acquisition—are typically a recipe for disaster. Conversely, a focus on return on invested capital or economic value can be beneficial, but are unlikely to be sufficient to create extraordinary performance.

It is often the subtext of the proxy and the history of management/board activities that are the true determinants of company performance. The past is usually prologue and as a result, we spend a lot of time looking into management’s and board members’ history at other companies. When possible, we talk to other people who have worked with members of management in the past. The best case scenario is a management team that we have known and followed for several years.

Finally, there is the “sniff” test wherein we meet with management. CEOs in particular are usually good salespeople and are therefore usually highly effective at conveying the merits of their company. In a limited number of instances however, meeting with management can raise our internal, “danger: proceed with caution” antennas. In these instances, we proceed with extreme caution or not at all. We are also conscious of the opposite scenario in which we meet with a management team and fall in love with them and their pitch. We call this the “I’ve got a guy” syndrome and try to be cognizant of the potential risk inherent in this syndrome.

• Management
o Management is a bunch of thieves that outweigh the company’s cheapness
o The CEO or board are incentivized to allow a take-under
o Thinking there is a “guy” when there is not
o Misread of management incentives/motivations
• Board/Ownership
o The board is captured by a single or group of corrupt individuals
o The board is comprised of board members with a long tenure that don’t want to rock the boat
o A staggered board and or poison pill insulates the board from shareholder pressure
o The A/B ownership structure or captured board resists all positive changes
o Family members don’t sell or try to move the needle on a cash rich/cheap stock
• Other
o Misread of motivations of large/key customers or suppliers

Value and Balance Sheet Mistakes

At Cove Street we endeavor to outperform in down or choppy markets and keep pace with broader market performance in up markets. We view risk as the permanent loss of capital. Two key components of mitigating risk are buying at a price that embeds a reasonable margin of safety via positive business attributes and avoiding companies for which there is a risk that the balance sheet can quickly deteriorate.

The latter is far easier than the former. Excess balance sheet leverage can turn a minor business or people mistake into a capital impairing disaster. As a result, we try to avoid companies with excess leverage. Defining excess leverage is a more nuanced conversation, but it is generally a function of debt capacity. The nuance is that every company exists on a spectrum that starts with a single product, commodity cyclical and ends somewhere near mission critical diversified medical companies that are not subject to cyclical swings or secular issues. We also try hard to avoid already stretched balance sheet companies that are at or near covenant thresholds and have the need to refinance a maturity in the shorter. This is especially true if the circumstances bring the company into the clutches of a distressed lender.

A company that has a pristine balance sheet can quickly fall into the excess leverage trap if it undertakes enough value destroying acquisitions. On average, M&A is value destructive and we cast a wary eye towards “rollups”. However, in instances where the balance sheet remains largely intact or where the company is buying small (especially private) companies outside of auction processes, M&A is more likely to be accretive to returns. “Transformative” deals or deals outside of a company’s core competency that add another business leg are more likely to be value destructive and therefore less likely to pass through our investment sieve.

Even if a company passes our balance sheet tests and avoids value destructive M&A, there are still a host of mistakes that can arise from valuation. Industries and individual companies change over time, but historical multiples are inherently backward looking. Therefore, we try to avoid being stuck in industries with secular issues that enviable cause companies to “rerate” to a lower multiple and we try to avoid the temptation to robotically sell a company when a favorable change in industry dynamics results in higher multiples.

Sum-of-the-parts (SOTP) situations are fraught with potential valuation errors we try to avoid. The parts or company segments themselves may not be separable. Even if the parts are separable, the allocation of standalone company costs may make the resulting entity subscale. In SOTP valuations where there are real estate assets or other assets with little or no other information other than book value, we try to use significant discounts to book value and generally try to avoid these companies.

Most of the above referenced risks are related to avoiding mistakes that occur when buying a security, but selling can also result in mistakes. One of the greatest mistakes is selling a company that has the ability to compound (a so-called Buffett company) and potentially multiply in value upon the first major move in the stock price. In fact, due to what is know as the anchoring bias, there is often a voice that tells you to sell solely on the basis that the stock has hit our initial target price and thus has become “expensive.” Buffett companies are almost never inexpensive and will almost always appear to be near fair value. The non-linear nature of compounders and the fact that the majority of Buffett companies’ competitive advantages are not visible solely on the stated financials makes it very difficult to ascertain intrinsic value.

• Balance sheet
o Excess leverage
o Imminent need to refinance
o At or near covenants
o Cash burn accelerated faster than anticipated
• M&A
o Buying into a roll up that fails, most acquisitions are value destructive
o Transformative acquisition impairs an otherwise health company
• Valuation metrics
o Relying on historical multiples for a business whose dynamics have changed
o The company appeared separable under an SOTP but really is not
o Real estate or other hidden asset values are overvalued
o Less than book value resolves itself with book value falling
o Selling a compounder that is up 50% before it becomes a 10 bagger

The list of mistakes above is by no means exhaustive, but it serves as a useful heuristic that we incorporate into our investment process. We often joke that we endeavor to make new and interesting mistakes rather than repeating old mistakes. When new mistakes arise we will add them to our list and incorporate them into our process. At Cove Street we strive to produce a culture that avoids the mistakes above through the disciplined execution of our 4 stage research process with a long time horizon that produces a concentrated portfolio with a significant margin of safety.

This report is published for information purposes only. You should not consider the information a recommendation to buy or sell any particular security, and this should not be considered as investment advice of any kind. 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 data. Partners, employees, or their family members may have a position in securities mentioned herein.

Past performance is not a guarantee or indicator of future results. The opinions expressed herein are those of Cove Street Capital and are subject to change without notice. Consider the investment objectives, risks, and expenses before investing. These securities may not be in an account’s portfolio by the time this report has been received, or may have been repurchased for an account’s portfolio. These securities do not represent an entire account’s portfolio and may represent only a small percentage. You should not assume that any of the securities discussed in this report are or will be profitable, or that recommendations we make in the future will be profitable or equal the performance of the securities listed in this report. Recommendations made for the past year are available upon request.

CSC is an independent investment adviser registered under the Investment Advisers Act of 1940, as amended. Registration does not imply a certain level of skill or training. Additional information about CSC can be found in our ADV Part 2A.