It may surprise you to hear that we sincerely believe there are aspects of the investment management industry that are truly unique. Before you start to snicker, let us pose a question. In what other professional endeavor is your performance measured every second of the day? It is hard to think of many, professional sports aside. But, if you are an equity portfolio manager, the stock market blithely opines on your investment acumen each and every day the opening bell rings. As a result, clients have the ability to scrutinize your decision making at any interval they choose—and that comes with a lot of potential stress. Thankfully, we have cultivated an astute client base that understands that Cove Street manages for the long term and runs concentrated portfolios that look nothing like the indexes to which we are invariably compared. My sense is that in just about 100% of cases, our clients are not staring at the screen to see how our stocks are doing on a given day. But, even with that we are not (and frankly should not be) sheltered from being questioned on a fairly regular basis by our clients regarding all aspects of our process and past decisions.

None of that bothers us. Managing other people’s money in a highly competitive environment is by definition an exercise rife with setbacks. Just like the best baseball players in the world fail 60% to 70% of the time they come to the plate, even the best investment professionals are wrong quite often. What separates the legends from everyone else (in my estimation) is the ability to limit how much money you lose when you make a mistake. In insurance lingo, to succeed you need low frequency, low severity losses. If either one of those two are high, good luck holding onto your clients. In any case, investing to a large degree requires a humble acceptance of your own futility. (Anyone looking for a new job!?)

If you have followed Cove Street over the years or have read any of these letters, you know that we are doggedly self-reflective. Our process is designed to mitigate the risk of making the same mistakes over and over and we have built in continuous improvement mechanisms with the primary goal of protecting us from making new mistakes as well. We record what we are thinking at major decision nodes and then revisit past decisions to see what we got right and where we were mistaken. We diligence our companies—and the people who run them—deeply so that we properly identify the key variables. We also own up to our mistakes and are not afraid to address them directly with our clients. That is why we always start the quarterly discussion of recent performance with the largest detractors. Our collective loss aversion and humility demand it.

It is with all of that in mind that I want to discuss the idea of the counterfactual. For anyone who isn’t intimately familiar with the concept, think about the counterfactual as a single or set of outcomes that didn’t happen. In other words, if you are choosing between vacationing in Amsterdam and in Paris, and you choose Paris, then the counterfactual consists of what would have happened if you had chosen Amsterdam. Now, in most walks of life, there is no way to know what would have happened if you had chosen a different path. If someone makes the claim that he would have been much more successful if he had gone to UCLA as opposed to USC, there is no way to verify that claim. Maybe it is true and maybe it isn’t. There is always an infinite number of eventualities that did not occur—because just one did—and anyone who makes statements like these is to some extent plagued by a form of hindsight bias.

Those of us who work in investment management are “lucky” enough to participate in one industry in which you can to some degree measure the counterfactual. Specifically, both the stocks we didn’t buy and the ones we sold have not simply disappeared. Most are still quoted each day and their performance, since we made our decision, can be tracked as way to a measure the investment process. It is true that clients will rarely have much insight into the stocks we didn’t buy. We certainly keep track of them, often with painful memories sprinkled in with a number of process-validating, good misses. But, it is certainly possible to assess us based on what we sold by asking the question: what would performance have looked like if company X or Y had not been sold, all else being equal? Now, that last statement cannot be overlooked. All things are never equal and there is no perfect analysis of “what if.” However, I think it is worth briefly discussing a few examples of recent sales as a way to illustrate our sell discipline and highlight our risk management discipline.

As customary, we will start with a mistake: Zebra Technologies (Ticker: ZBRA). Zebra makes handheld computing and printing devices that are used in warehouses and retail stores. We started looking at the stock after the company had made a very large deal in buying a division from Motorola Solutions. Our contrarian position was that it was the messy merger that was holding back margins and revenue growth, and that over time, Zebra would emerge less levered with higher cash flows. Our scenario basically played out as planned (some luck, some skill) and we took a victory lap by selling the stock when it got to around $110 in late 2017. At that point the stock had hit our “infallible” price target and we were (ignorantly) happy to sell what we perceived at the time to be an expensive stock. From there, due to superb execution by management, and admittedly some multiple expansion, the stock promptly went into the $200s and is right around that price today.

Clearly, this was a bad sale. So what did we miss? We simply underestimated the quality of both the people and the business. With respect to the latter, we did not appreciate the level of margins the company would be able to achieve. While in hindsight this feels like a painful mistake, I will admit that ones like this are inevitable. We have a process that dictates we sell our “Graham-like” companies when they get to fair value. We saw plenty of competitive risks but in the end, the Zebra business in fact had more “Buffett-like” characteristics than we initially thought. The lessons here is that we must continuously get better at evaluating business quality so that we can feel more comfortable holding onto compounders even if they are priced north of fair value.

Now, let’s move to some decisions that have, at least to date, worked out much better. So far in 2019, two of the companies in the portfolio—Henry Schein (Ticker: HSIC) and FMC Corp. (Ticker: FMC)—have spun off smaller divisions to their shareholders. Henry Schein spun off its animal health segment, Covetrus (Ticker: CVET), after it was merged with a company called Vets First Choice. FMC spun off its lithium segment, Livent (Ticker: LTHM), to focus solely on its agricultural chemicals division. Given that we own FMC and HSIC, we were very familiar with these businesses but we nonetheless doubled down on our diligence efforts after the spins were announced. The industry research and former employee calls that we did gave us an inkling that we might not want to own the spins as independent, standalone companies for the long-run—for a variety of different reasons.

In the case of Covetrus, the company was spun with a little more leverage than we were comfortable with. In addition, we were concerned that the Vets First Choice’s business model was still maturing and that the fast growth it had achieved was not particularly sustainable. When we received the shares they were in the low-$30s and we had to make the sell or hold decision. As such, we looked at the healthy valuation, we considered our misgivings and very quickly decided to sell the shares. The stock now trades under $12. It is certainly down a lot and we continue to follow the company. But, we remain somewhat gun-shy, mainly because of the balance sheet.

When it came to Livent, we did a lot of work to try to determine if this was a business we could own for the long-run. Livent has a very attractive asset base from which to extract lithium. Further, if you believe the estimates regarding how many electronic vehicles (EVs) are going to be on the road by 2030, the world is going to need a lot of lithium for the cars’ batteries. The issue is that lithium is a commodity. There are definitely factors that make the market more interesting to us than the natural gas market, for example, but Livent remains a price taker when it comes to the price at which the company can sell its lithium. Also, the company is embarking on a large capital expansion initiative in order to be able to serve the demand it foresees over the next three to five years, a plan that will require the company to add some debt. The combination of Livent being subject to wildly fluctuating market pricing, the uncertainty around eventual EV demand and the required debt accumulation suggested to us we should sell our shares. Since the spin date, the stock has fallen more than 50% and has been another good miss. Is the stock more interesting now? Maybe. We have subsequently learned more about the lithium industry and there are certain dynamics that are suggestive that Livent is a stock we could own at the current price. We are doing more work, and in fact, the company’s CEO was in our office this past week.

I will sum up by discussing what all of the above suggests about Cove Street’s buy and sell discipline. We are very selective about the businesses we own and we intentionally avoid levered companies and businesses that do not have sustainable competitive advantages. In addition, we will probably sell some businesses we are not sure about too early—as well as buy other great companies before the stock price eventually bottoms. Being early is part and parcel to being a value investor. The above stocks represent isolated examples but the bigger themes remain the same.

– Ben Claremon | Principal, Portfolio Manager, Research Analyst

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