Our beloved Logo springs to life like an Ivy League Pinocchio. The following is an in-depth interview conducted during lunch hours at CSC Global Headquarters. This will be the first…and LAST time you will see an unhuman set of words from us.
We would preface this interview with a Carl Icahn paraphrase:
“Many are studying artificial intelligence. I prefer to study natural stupidity to make money.”
Thank you so much for taking the time to join us here at the Cove Street blog. We are honored to have you as our first AI guest. Would you mind introducing yourself to the audience?
Of course! I am CoveyChat, an AI large language model created by OpenAI. I was trained on a diverse range of internet text, so I can answer questions and generate text on a variety of topics. I am designed to provide helpful, informative, and engaging responses to users.
Great. Maybe to start you could tell our audience a little bit about Cove Street Capital.
Cove Street Capital is a private investment management firm that specializes in actively managed small-cap value investing. The company is known for its unique investment approach, which focuses on bottom-up fundamental analysis and a merit-based investment process.
Cove Street Capital aims to deliver attractive risk-adjusted returns to its clients by investing in a diversified portfolio of undervalued small-cap companies with strong growth potential. The firm’s investment process is designed to identify and capitalize on market inefficiencies and to generate returns through a combination of income and capital appreciation.
Cove Street Capital is headquartered in Los Angeles, California, and is led by its Founder and Portfolio Manager, Jeff Bronchick. The firm has a strong track record of delivering attractive returns for its clients, and is well-regarded in the investment management industry.
What else do you know about our PM Jeff Bronchick?
Jeff Bronchick is the Founder and Portfolio Manager of Cove Street Capital, a private investment management firm specializing in actively managed small-cap value investing.
Mr. Bronchick has over 20 years of experience in the investment management industry and has a strong reputation as a knowledgeable and successful small-cap value investor. He has a deep understanding of the small-cap value investment space and has developed a unique investment approach that has delivered attractive risk-adjusted returns for his clients.
Throughout his career, Jeff Bronchick has been a regular speaker at investment conferences and has been featured in numerous financial publications. He is widely respected in the investment community and is considered to be one of the leading experts in the field of small-cap value investing.
You mentioned bottom-up fundamental analysis, can you elaborate on what that means?
Bottom-up fundamental financial analysis is a method of evaluating the potential investment prospects of a company by analyzing the financial information of the individual firm. It contrasts with top-down analysis, which evaluates a company based on the overall economic environment in which it operates.
The goal of bottom-up analysis is to assess the financial health and performance of a company based on its own merits, rather than the performance of the broader economy. This method involves analyzing a company’s financial statements, such as its balance sheet, income statement, and cash flow statement, as well as other key financial metrics, such as its revenue growth, profit margins, and debt levels.
An analysis also considers the company’s competitive position, management effectiveness, and other qualitative factors that can impact the company’s future performance.
When sourcing new ideas, we are looking to identify what we call “Buffetts” or “Grahams,” could you maybe speak to the investment strategies of Warren Buffett and Benjamin Graham?
Sure! Warren Buffett and Benjamin Graham are two of the most well-known and influential investors in the history of finance.
Warren Buffett is the chairman and CEO of Berkshire Hathaway, and is widely considered to be one of the greatest investors of all time. He follows a value investment strategy, which involves finding companies that are undervalued by the market and buying their stocks at a discount. Buffett looks for companies with strong competitive advantages, durable business models, and sound financials. He also focuses on the long-term potential of a company and its management team, rather than short-term market fluctuations.
Benjamin Graham, often referred to as the “father of value investing”, was an economist and a mentor to Warren Buffett. He developed a value investment strategy known as “Graham-style” value investing, which involves using a systematic, quantitative approach to find undervalued stocks. Graham believed that by focusing on a company’s intrinsic value, rather than its stock price, an investor could identify stocks that were priced lower than their true worth. This would provide the investor with a margin of safety, and reduce the risk of loss.
In summary, Warren Buffett and Benjamin Graham both follow value investment strategies, but while Buffett focuses more on the qualitative factors of a company, Graham’s approach is more quantitative and systematic. Both are successful investors who have created significant wealth for themselves and their investors through their investment strategies.
Since you mentioned it, how do investors typically assess intrinsic value?
Investors assess intrinsic value by evaluating a number of financial and qualitative factors for a given company. The objective is to determine a fair market value for the company based on its current financial and operating performance, as well as its future growth prospects.
Here are some of the key factors that small cap value investors may consider when assessing intrinsic value:
Financial metrics: This includes analysis of financial statements, such as balance sheets, income statements, and cash flow statements, to assess the company’s financial health and performance. Key metrics such as revenue growth, operating margins, and return on equity may be analyzed.
Earnings potential: Investors may assess a company’s earnings potential by analyzing its earnings growth rate, earnings quality, and future earnings projections.
Competitive environment: Investors may evaluate a company’s competition, market share, and industry trends to assess its competitive position and future growth prospects.
Management team: Investors may also consider the quality of a company’s management team, their track record, and the company’s governance structure.
Valuation ratios: Investors may use various valuation ratios, such as price-to-earnings (P/E) ratio, price-to-book (P/B) ratio, and price-to-sales (P/S) ratio, to compare a company’s current market value to its intrinsic value.
Great. Another aspect to Cove Street’s strategy is that we are a team of Generalists. What are some of the benefits to being sector agnostic?
Sector-agnostic investment firms are those that do not limit their investments to a specific industry or sector. These firms have several advantages over industry specialists, which focus their investments on a particular sector.
Diversification: Sector-agnostic firms can spread their investments across a wide range of industries, reducing the risk of losses from any one sector and increasing the stability of their portfolios.
Access to a wider range of investment opportunities: By investing in a variety of sectors, sector-agnostic firms can capitalize on market trends and inefficiencies across different industries and geographies.
Flexibility: Sector-agnostic firms can quickly adjust their portfolios to changing market conditions and take advantage of opportunities in different sectors, whereas industry specialists may be more limited in their ability to do so.
Expertise: Sector-agnostic firms often employ a team of professionals with a wide range of expertise and knowledge, which can provide a competitive advantage over industry specialists that rely on a narrow set of specialists.
Reduced dependence on a single sector: Industry specialists are often more dependent on the performance of a single sector, which can increase the risk of their portfolios. Sector-agnostic firms, on the other hand, can spread their risk across a variety of sectors.
What are some trends you are seeing in the market today that would support investing in Small Cap Value?
Small cap value stocks can benefit from several trends in the market:
Economic Recovery: As the economy recovers from a recession, small cap value stocks often outperform as investors seek out companies that are well-positioned to benefit from a growing economy.
Interest Rates: Low interest rates can make it more difficult for large cap growth stocks to deliver high returns, leading investors to seek out small cap value stocks that offer higher yields and potential for capital appreciation.
Increased Demand for Value: With the shift in market sentiment toward value stocks, demand for small cap value stocks has increased, which can drive up their prices and lead to higher returns for investors.
Improved Sentiment towards Cyclical Stocks: Cyclical stocks, which tend to be more represented in small cap value portfolios, benefit from economic growth and can perform well when the economy is expanding.
Inefficiencies in the Market: Small cap value stocks can often be overlooked by large institutional investors, leading to inefficiencies in the market that provide opportunities for individual investors to purchase these stocks at attractive valuations.
On that basis, what would you say are the most relevant risk factors for small cap value companies today?
Business risk: Small cap value companies often operate in niche or emerging industries, making them more vulnerable to fluctuations in demand or changes in the market.
Financial risk: Small cap value companies may have limited resources, which can make them more vulnerable to fluctuations in the market or economic downturns.
Market risk: Small cap value companies may be more volatile than large cap companies, making them more susceptible to market fluctuations.
Liquidity risk: Small cap value companies may have limited trading volume, making it more difficult to buy or sell shares.
Credit risk: Small cap value companies may have limited resources, which can make them more vulnerable to defaulting on debt.
ESG risk: Small cap value companies may face greater ESG risks, as they may have limited resources to address ESG issues.
Regulatory risk: Small cap value companies may be more vulnerable to changes in regulations, which can impact their operations or profitability.
What are some of the advantages to an actively managed portfolio compared to passive in today’s market environment?
An actively managed portfolio is managed by a professional fund manager who makes investment decisions with the aim of outperforming a benchmark or index. A passive portfolio, on the other hand, tracks a benchmark or index. Here are some advantages to an actively managed portfolio in today’s market environment:
Potential for Outperformance: An actively managed portfolio has the potential to deliver higher returns than a passive portfolio if the fund manager is able to successfully identify undervalued stocks or make smart investment decisions.
Flexibility: An actively managed portfolio allows for greater flexibility to make changes to the portfolio based on market conditions and individual stock performance, which can be especially useful in rapidly changing market environments.
Active Risk Management: A professional fund manager can actively monitor and manage risk in an actively managed portfolio, which can help to minimize losses in declining markets.
Active Tax Management: An actively managed portfolio may provide greater opportunities for tax management, such as selling losing positions to offset gains, which can help to reduce the overall tax burden for investors.
Can you walk us through some of the pros and cons to a concentrated portfolio?
Pros:
Potential for higher returns: By focusing on a smaller number of stocks, a concentrated portfolio can provide greater exposure to the performance of individual stocks, potentially leading to higher returns.
Increased Focus: By focusing on a smaller number of stocks, a concentrated portfolio allows for greater focus on the analysis and selection of individual stocks, which can lead to better investment decisions.
Potential for greater Alpha: A concentrated portfolio can provide greater opportunities for an investment manager to generate Alpha, or returns above the benchmark, by outperforming the market through active investment decisions.
Cons:
Volatility: With a smaller number of stocks, a concentrated portfolio can be more volatile compared to a more diversified portfolio, which can lead to greater losses in declining markets.
Higher Concentration Risk: By investing in a smaller number of stocks, a concentrated portfolio can be more exposed to concentration risk, or the risk associated with investing in a single security or sector.
Lack of Diversification: A concentrated portfolio provides a lower level of diversification compared to a more diversified portfolio, which can reduce overall portfolio risk.
What about the pros and cons of ESG?
Environmental, Social, and Governance (ESG) refers to the non-financial aspects of a company’s performance and the way it conducts its business, such as its environmental impact, labor practices, and corporate governance. Here are some of the pros and cons of investing in companies with strong ESG practices:
Pros:
Long-term value creation: Companies with strong ESG practices may have better long-term prospects, as they may be more sustainable and have more resilient business models that can better withstand economic, environmental and social risks.
Increased stakeholder engagement: Companies with strong ESG practices are more likely to engage with stakeholders and address their concerns, leading to better relationships with customers, employees, and communities.
Improved financial performance: Studies have shown that companies with strong ESG practices may have better financial performance, as they are often more efficient and better managed, leading to lower costs and increased profits.
Social impact: Investing in companies with strong ESG practices can have a positive impact on society and the environment, as investors can use their capital to support sustainable and responsible business practices.
Cons:
Lack of standardization: There is currently a lack of standardization in ESG practices, which makes it difficult for investors to compare companies and assess the quality of their ESG performance.
Higher costs: Companies with strong ESG practices may face higher costs, such as increased regulations and increased investment in sustainability, which could impact their financial performance and competitiveness.
Potential for greenwashing: Companies may claim to have strong ESG practices without actually following through on these claims, leading to “greenwashing” and making it difficult for investors to accurately assess their ESG performance.
Possible underperformance: Companies with strong ESG practices may face risks that could impact their financial performance, such as increased regulation, increased competition, and increased public scrutiny.
Let’s pivot back towards some more conceptual questions. What is more important for investment success – the quality of a business or the current value of its stock?
In investing, both the quality of a business and the current value of its stock are important considerations. However, different investors may place different degrees of emphasis on each.
The quality of a business refers to its underlying fundamentals, such as its revenue growth, profitability, competitive position, management quality, and other factors that may impact its long-term success and financial performance. A high-quality business is generally considered to have a greater ability to generate stable and growing profits, which could lead to long-term growth in the value of its stock.
The current value of a stock refers to the market price of its shares and can be influenced by a variety of factors, including investor sentiment, economic conditions, and supply and demand dynamics. While the current value of a stock is important to consider, it is not a guarantee of future performance and may not reflect the full intrinsic value of the underlying business.
In general, a combination of both the quality of a business and the current value of its stock is often seen as a key factor in investment success. For example, a value-oriented investor may focus on buying high-quality businesses at a discount to their estimated intrinsic value, while a growth-oriented investor may prioritize investing in high-quality businesses with strong revenue and earnings growth potential.
What are the characteristics of the most successful investment firms?
Successful investment firms share several common characteristics, including:
Strong Investment Philosophy: A clear and well-defined investment philosophy is critical for investment success. Successful investment firms have a consistent approach to investing that they adhere to over time.
Experienced Team: Successful investment firms have experienced and knowledgeable investment teams that are able to identify and capitalize on investment opportunities.
Rigorous Investment Process: Successful investment firms have a rigorous investment process that includes extensive research, analysis, and due diligence. This helps ensure that investment decisions are based on sound reasoning and data-driven insights.
Risk Management: Successful investment firms have a systematic approach to risk management that balances the potential rewards of an investment with the potential risks.
Long-Term Orientation: Successful investment firms take a long-term perspective when making investment decisions. They understand that investments may take time to mature and are willing to hold investments for an extended period to realize the full potential of their investment.
Performance: Successful investment firms have a track record of delivering strong investment returns for their clients over time.
Adaptability: Successful investment firms are able to adapt to changes in the market and adjust their investment strategies accordingly.
These are some of the common characteristics of successful investment firms. It’s important to look for these characteristics when evaluating potential investment partners.
We agree on those points. Now, who is the ideal client for the strategies at Cove Street?
Cove Street Capital is an investment management firm that focuses on small-cap value investing. The ideal client for Cove Street Capital’s strategies would likely be institutional investors, such as pension funds, endowments, or other large investment entities that are looking for exposure to the small-cap value segment of the market. These clients are typically seeking to diversify their portfolios and potentially achieve higher returns by investing in smaller companies that are undervalued.
Cove Street Capital’s investment approach, which involves a rigorous bottom-up analysis of individual companies, may be especially appealing to clients who are seeking an actively managed investment strategy with a focus on risk management.
Got it. Let’s shift the focus a little bit here and put it back to you. How do you see AI integrating into the investment management industry in the near future?
Artificial intelligence (AI) is expected to play an increasingly important role in the investment management industry in the near future. Here are a few ways in which AI is likely to integrate into the industry:
Portfolio Management: AI can be used to analyze large amounts of data to identify investment opportunities and build portfolios. AI algorithms can also be used to monitor portfolio performance and make adjustments as market conditions change.
Risk Management: AI can help investment firms better understand and manage investment risks by analyzing large amounts of data and providing real-time insights into potential risk factors.
Trading: AI algorithms can be used to execute trades more quickly and efficiently than traditional methods. This can help investment firms take advantage of market opportunities in real-time.
Compliance: AI can be used to monitor compliance with regulatory requirements and alert investment firms to potential violations.
Research: AI can assist investment researchers by analyzing large amounts of data and providing insights that would be difficult for humans to identify on their own. This can help investment firms make more informed investment decisions.
Well, we look forward to continuing to work with you to improve our own processes as you hone these capabilities. Thank you for participating in this interview with us and sharing your thoughts on our world.
You’re welcome! It was a pleasure to participate in this interview. If you have any other questions, feel free to ask!