(The following is an excerpt from the Q3 Small Cap PLUS letter to investors)

We view our portfolio as a collection of idiosyncratic, measured bets on businesses that are getting more valuable over time but, for some reason, are slightly out of favor. Or, in the case of Lumen Technologies (Ticker: LUMN)—our largest position—totally out of favor. I think you can also include Lions Gate Entertainment (Ticker: LGF.B)—our newest position—in the very much hated bucket. And it was thinking about those positions and other investors’ reactions to them that inspired me to tackle the topics of investing with catalysts and stock maturity.

Unlike bonds, stocks don’t have a fixed maturity date. Assuming no outside forces conspire—either benevolently or malevolently—to make a company de-list, the company will continue to be publicly traded indefinitely. They are long-duration assets. But some will inevitably have a longer duration than will others. As an investor, sometimes it would be great for certain stock to have a “maturity.” When a company has a piece of debt maturing, it generally has to either refinance or pay it off with cash. In either case, a capital allocation decision must be made. With stocks, there aren’t that many situations where management is forced to decide about whether to continue on as a public company with the same assets and business model, sell to someone else, or simply throw in the towel.

In many ways, being in control of when an investment matures is the attraction of private equity funds. In most cases, as a fund gets toward the end of its life, the private equity firm must figure out what to do with the companies that are still owned. This defeats inertia and causes internal motion. Of course, being a forced seller is probably not ideal. But, for certain public companies—especially those whose per share asset value or sum-of-the-parts value is much higher than its stock price—having a fixed maturity might actually lead to a higher value for investors. Continuing with the bond analogy, it would force the management team to assess if the present value of the operating plan is higher than the price the company could get in a sale today. If so, you continue on (the refinance and extend option), and if not, you sell (the ‘pay off the debt’ option).

I am sure there would be all kinds of unintended consequences if such a system of stock maturities existed. (For instance, think how much money the investment banks would make!) But, the broader idea is that in certain cases it is very important for company executives to step back and evaluate the best path forward for shareholders. I would argue this is especially true for companies who have underperformed their peers and indexes over a long period of time. Situations like these typically entice activist or suggestivist shareholders to step in and help. If you build up a big enough stake or establish enough credibility with a management team, you can effectively influence the decision-making regarding whether it makes sense to try yet another turnaround, yet another new CEO, or yet another acquisition to get the growth engine going. Sometimes, especially when there are other parties who are paying very nice multiples for the types of assets that a company controls, it makes sense for ALL stakeholders (not just those pesky, short-term-oriented, greedy shareholders) for the company to find a new home for certain businesses or the whole company.

Let me step back for a second to talk about our strategy. We don’t go looking for companies that we think should sell themselves. I firmly believe that it is a fool’s errand unless you have tens of billions under management and can force the company to sell—similar to how activists such as Elliott Management operate. Every investor can come up with plenty of potential acquirers of companies and reasons for why a company will sell. But, the base case is that most of the companies in your portfolio WILL NOT sell themselves within a timeframe that your clients will endure, and thus, buying a stock simply because you think the company will—or should—sell, is not a way to outperform over the long run. We typically prefer to buy businesses that are getting more valuable every day, that are run by people who understand capital allocation and that trade at a modest discount to intrinsic value. And, if someone else recognizes the cash flows, the compounding, and the undervaluation and wants to offer us a good price, so be it. We are seeing this with our holding, TEGNA (Ticker: TGNA), right now. But, in most cases, we don’t bank on that catalyst. We want to be OK with either receiving a fair price today or with owning the business over a three-to-five-year time horizon (and hopefully much longer).

As mentioned above, we own an eclectic portfolio of stocks for which the path to a higher stock price is not necessarily uniform. We certainly prefer to own prototypical compounders (check out the Compounders podcast for more details), especially when there are some short-term headwinds impacting the stock. FMC Corp (Ticker: FMC) is a perfect example of such a security. But, there are other categories of stocks we will periodically consider. Here is the way I would bucket our current portfolio and the types of situations we get interested in:

• Compounders
• Growth cyclicals
• Value creators
• Abandoned incumbents
• Underappreciated cash flowers
• True believers
• Stocks nearing maturity (AKA special situations)

To help people better understand our definition of value, I think it is worthwhile to go through the non-compounder categories (some of which may be overlapping) and highlight certain examples, starting with so-called growth cyclicals. With these stocks, there is some cyclicality in the end markets but there are secular tailwinds that will benefit the companies over the long run. Sensata Technologies Holding (Ticker: ST) and Howmet Aerospace (Ticker: HWM) are prime examples of a growth cyclicals. Automotive and commercial aerospace markets do have ups and downs, but the general trend should be up for both companies.

Next, we are predisposed to investing alongside what I would call value creators: companies run by people who actively manage their portfolio of businesses in order help close the gap between intrinsic value and the stock price. Examples of these are Liberty SiriusXM Group (Ticker: LSXMA) and Colfax (Ticker: CFX), the latter of which is currently in the middle of splitting into two companies.

While it may not be for everyone, we will also at times consider abandoned incumbents. In a world where disruption is all the rage, it is our sense that many investors assume incumbents will be disrupted regardless of the size of the moat. In other words, in certain circumstances, we will bet against the idea that a fancy app can disrupt any business model. We currently don’t own many of these but for sure Western Union (Ticker: WU) fits that bill. Our research suggests that WU has an unappreciated but unmatched network that has been made even more valuable by the investments in its digital business. Western Union also is what I would deem an underappreciated cash flower, or a company that generates a ton of cash and trades at a very undemanding multiple. Other examples of such stocks are Tapestry (Ticker: TPR) and Spectrum Brands Holdings (Ticker: SPB), two companies that trade at large discounts to similar companies in their space. By the way, companies like these are often great targets for private equity take-outs due to the cash flow characteristics.

The next category, true believers, is sort of a catch-all for companies that screen terribly if you pull up their CapitalIQ tearsheet but whose future we believe is incredibly bright. These are often controversial, battleground-style stocks. Within our portfolio, Viasat (Ticker: VSAT) is the poster child but you can also include Millicom International Cellular S.A (Ticker: TIGO) in this bucket. If you want to learn more about either of these, we recently had the Executive Chairman of VSAT and the CEO of TIGO on our podcast and both gave very compelling reasons for why the future is indeed going to look a lot better than has the past.

Now, to address the last category from above, let’s go back to where we started—with Lumen Technologies and Lions Gate Entertainment. We most certainly see these as special situations or stocks that are nearing the point of maturity. The management teams of these companies have overseen such meaningful underperformance that the status quo is no longer an option. Neither of these is a typical compounder. Both have some parts of their business that are attractive and theoretically have growth prospects, while other parts of the companies are definitive non-growers or shrinkers. In our humble opinion, this mix makes it hard for Wall Street to value the companies properly. But, both of these companies have been “cheap” on a sum-of-the-parts (SOTP) basis for years. Why is now different? Isn’t it potentially a sub-optimal strategy to consistently invest in businesses that may not be getting more valuable every day just because they are cheap? Isn’t that how you get a value trap?

The answer to the last two questions from above is a definitive yes. But what is different is that our research suggests that there is internal momentum to highlight the value of the assets and explore strategic alternatives that would close the gap between the stock price and intrinsic value. Not in three years or when the management team is about to retire, but now.

Starting with our largest position, we have discussed LUMN extensively and actually just did another podcast interview focused specifically on LUMN. The simple takeaway is that LUMN is divesting two non-core assets at very attractive valuations relative to the stock’s current multiple. After these sales are completed, the RemainCo will consist of the more attractive assets, and yet the stock is basically unchanged since the announcements. Accordingly, our sense is the market is missing that the asset sales suggest an even higher value for LUMN than we originally underwrote. More importantly, we see tangible evidence of attempts to generate a higher stock price and hear consistently from management that the company is not done. When we first invested in LUMN, we didn’t have that catalyst and now it is present. We are looking forward to seeing what else management has up its sleeve over the next year or so.

We will now turn to Lions Gate Entertainment. The Lions Gate and Lumen situations have some similarities, but the main difference is that, while there are parts of Lumen that are getting less valuable over time, one could argue that Lions Gate’s library of movie and TV shows has become even more valuable, especially recently. Lions Gate in its current form is the result of the merger of legacy Lions Gate and Starz, the premium cable TV company that was previously controlled by John Malone and Liberty Media. It has been somewhat of a rocky marriage (just look at the stock’s putrid relative and absolute performance since the acquisition) but that doesn’t mean the company has not created value since the deal closed in late 2016. Starz used to essentially be a throw-in by the cable companies as part of a promotional package of some kind. Now, situations like that are down to about 20% of subs. The rest of the ~29 million subs are ACTIVELY choosing to subscribe. Additionally, Starz has a growing international subscriber base, albeit at a cost of $140 million per year in international operating losses.

What does the market dislike about Lions Gate? Here are the top five complaints we hear:

1. The person who controls 23.2% of the voting shares, one Mark Rachesky, is a “never sell bro” and will block any potential suitors (similar to how someone, possibly Rachesky, turned down a Hasbro (Ticker: HAS) bid in 2017).
2. The debt levels are too high for a company that is spending so much on Starz’s international aspirations and has a studio business that is still heavily impacted by COVID.
3. The founders of the company, despite getting up there in age, will never allow anyone else to control their baby.
4. No one watches Starz (at least when compared to HBO and Showtime) and only a company that was totally biased and irrational could think that the brand has any sustainable international appeal.
5. The stock has for years looked undervalued on an SOTP basis but, given #1 and #3 above and the fact that no single entity would want to own both Starz and legacy Lions Gate, there is no way for minority shareholders to realize intrinsic value.

Let’s discuss these items. First, when it comes to Rachesky, he has absolutely sold shares in the past but that was when the stock was over $30 versus about $13 today. You can never know what someone truly believes but our sense is that he is an economic animal and that the content world has changed just a bit since 2017.

Second, yes, the debt levels are elevated but some of that is due to how COVID has impacted the business. Assuming that pressure abates over the near term, that outcome—in conjunction with the monetization of the significant amount of new content that Lions Gate will be producing within the television segment—should alleviate some of the concern. Plus, if they either gave up on Starz international being a global direct-to-consumer (D-to-C) powerhouse or were able to get that business near profitably, it would go a long way toward making the balance sheet look stronger. On that note, the company strongly believes that it has the right to play in the international D-to-C streaming world, despite the competition. The pitch is that Starz is a niche product that certain demographics actively seek out due to its originals and to some degree the Lions Gate films that also come with the package. The team at Cove Street is admittedly somewhat skeptical of how well Starz’s original series will travel outside the US but we are comforted by a few things. First, Starz was early in trying to expand outside the US, so it does have some advantages when it comes to distribution relationships. Second, as opposed to trying to sell directly to Malaysian consumers, unlike the Disney+ approach, in new markets Starz is working with distribution partners who are aligned with upselling their existing customers to subscribe to a premium offering. Third, the company swears that it will stop losing money outside the US if it doesn’t see significant traction. So, while the short-term hit to Starz’s profitability is painful, it shouldn’t last forever.

Next, Vice Chairman Michael Burns is 62 years old, and CEO Jon Feltheimer is 69 (according to the 2021 proxy statement). The question is, are these gentlemen willing to consider strategic alternatives that maybe they weren’t back in 2017? Our premise, which has been echoed by people at the company, is that two recent transactions are weighing materially on the minds of the LGF board and management team: Amazon buying what appears to be an inferior MGM library for $8.45 billion and Blackstone buying Hello Sunshine (which has basically no library) for $900 million. We recently listened in on a call hosted by J.P. Morgan with LGF board member Gordy Crawford where, based to some degree on what Amazon is paying for MGM, he laid out an SOTP for the company that summed to $33. There is a lot of room between $13 and $33 so even if you haircut Lions Gate’s superior library a fair amount, it appears that there is a meaningful margin of safety at the current price. So, will they sell? Who is the buyer? We can’t know the answers to those questions but, to answer #5 above as well, we think the value is there and that—just like at LUMN—there is internal momentum to realize the value of the assets.

(If you want to dive even deeper into Lions Gate, please see a recent presentation I gave on the company on the Market Champions podcast.)

We could go on and on about Lions Gate and Lumen, but the takeaway is that our research suggests these two companies are getting close to their maturity and if that indeed did happen and they received anywhere near what we think the assets are worth, they would be huge contributors to this strategy’s performance. In the meantime, we promise to continue to look for evidence that disconfirms our stated hypotheses regarding these companies. Further, given that they are both special situations and not typical compounders, they both most certainly have a shorter leash when compared to our other positions.

-Ben Claremon