As analysts, we are tasked with identifying companies that can produce favorable risk adjusted returns with a substantial margin of safety. Like any number of people – but apparently not that many – we model history on spreadsheets and attempt to use that baseline math to make reasonable assessments of the future.

Although we recognize that our spreadsheets are an important mechanism for evaluating value, they are by no means the only mechanism. Additionally, the accuracy of any model deteriorates over time beyond the first few years. Therefore, being directionally correct is far more important than being precise.

In many cases the vast majority of a company’s value, in a saying oft used by our glorious leader, renowned husband and father, and allegedly decent guitar player, Jeffrey Bronchick, CFA “off the spreadsheet.” Some of Cove Street’s most successful investments have been instances where the value was not immediately clear based on present financials. Rather there are often enormous qualitative factors that are difficult if not impossible to model that result in substantial value accretion overtime. As said leader often points out, it is precisely because these factors require substantially more diligence to ascertain and are often not model-able, they are largely if not entirely missed by quantitative funds, the sells-side, and index hugging active managers.

The following is a non-exhaustive list of the factors that we look for to identify value off the spreadsheet, and will cover in depth below.

People
–  A stellar management team
–  Favorable personnel changes in management or the Board

Headline Numbers Don’t Lie. People Do
–  Beware of Management Offering Shiny Gifts in a Press Release
–  Under earning due to a weak subsidiary or major investments that are not producing current income
–  Hidden assets that are not being monetized

Buffetts
–  Nonlinear nature

People
Can you model Buffett? Malone? Singleton? Mendelson? Jobs? Bezos? Management and the Board are crucial to a company’s long-term success and by far the most difficult variable to get right in an investment. And again, spending time on things that are not model-able can be a highly differentiating source of value addition. The past can be prologue and a CEO that was successful in the past has a better than fighting chance of being successful in the future. We are staunch supporters of the notion that one does not become stupid overnight – it takes time and diligence.

Of course nuance and caution is warranted, as a CEO could have been successful due to a market cycle or simply had a great starting hand. Although a superstar CEO who has successfully produced value at a public company in the past is easily identifiable and will be given credit by the market, in many cases a successful private company CEO will not be accorded the same reception.

Similarly, it is very difficult to ascertain whether an extraordinarily accomplished division manager will turn into a great public CEO, as our wounds can attest.  At Cove Street we extensively vet a CEO by speaking with their former colleagues and competitors to gauge their capital allocation, managerial, and operational acumen. Equally importantly, we seek to find out if the CEO passes a basic smell test. Is this CEO a decent person or someone that is liable to misappropriate capital for their own gain, attempt to empire build, or try to sleep with an underling?  (The latter occurs way more frequently than one would expect. We have encountered at least half a dozen times in the last 5 years alone where a CEO has been fired for said behavior.)

Also important to this process is the Board, which generally is responsible for the comp plan. Aligned with us or against us? Time based vs. incentive-based performance pay? Is someone actually putting up their own cold, hard cash or just the beneficiary of an annual give?

Board members can reorient firm strategy on a more secure footing or provide a CEO with better strategic or financial direction. A solid new Board member can also help a Board make difficult, but necessary actions—such as a dividend cut or layoffs to right size a company’s cost structure.  In extreme cases a new Board member can shake up an ossified Board and push for the divestiture of weak segments or the sale of the whole company. And again, has a Board member put up cash—or just been a receiver of gelt?

A Board member who is likely to pursue a sale or divestiture is worth their weight in gold. We at Cove Street look very closely at Board members and their past Board affiliations. If the new Board member had previously been appointed to a Board and within a year or two a company sale occurred, that is generally a good sign. More research is usually warranted as it could be pure coincidence, but if diligence indicates that the individual was the one pushing for a sale, it increases the probability they will do the same when faced with a similar situation.

Board members who hold a lock on a Board through either their position as the chair person or ability over time to stack the Board with their friends can be value destructive. These lead directors often stymie value accretion because they benefit financially from the status quo. In the worst scenarios, they serve as an impasse to a company sale because they would lose their cushy position if the company was sold. We have encountered several instances where the majority of a Board was not necessarily nefarious but would blindly follow the lead of a bad apple director. When the bad Board member is finally removed or a new aggressive value-oriented Board member is present that removes the bad Board members lock on the Board, value can quickly accrue.

Headline Numbers Don’t Lie…People Do
Well, lying may be a strong word, but it can get close to accurate. We spend of lot of time trying to understand incentives for action and it is fair to say that the management of all public companies want their stock to go up. So they naturally point to attributes of their business and results that highlight the good parts and ignore or downplay the bad parts. Let’s keep it simple and just say “adjusted” earnings.

Now that is actually why we do spreadsheets – to properly understand what we think we are being told and actually quantify it. Do earnings equal cash? Are we getting a return on investment that is sufficient? Why do you trumpet share repurchase when your shares outstanding just aren’t going down? (They are running employee comp through the cashflow statement and not the income statement.)

We live in an age where trillions of dollars are allocated via quantitative strategies. These strategies tend to look at headline numbers from press releases and extrapolate valuations. Similarly, active managers with a massive number of positions (index huggers) that effectively try to replicate indexes rarely have the time to understand a company in depth. As a result, the nuances of a company’s operations or asset base are largely missed by both sets of investors.

Companies frequently have segments or a portion of a division that is massively under earning or is currently a drain on the firm’s profitability and returns. In some cases the division is developing nascent technologies, entering new markets, or spending to ramp a new contract where a return will take some time to materialize. In other instances management is wasting money on projects that will never produce a return. Companies may also simply have a highly profitable division within a much larger segment that is highly cyclical or obscured by other parts of the division. In all these cases, a quantitative investor or index hugger will miss the potential for substantial value accretion when the spend starts to produce returns, the spigot is shut off on the wasteful projects, or the niche division starts to turn or is highlighted.

Hidden assets are similarly difficult to see based on present financials. For a real estate company or company with substantial real estate holdings, a hidden asset could be real estate that is held at ancient book values or properties that are irreplaceable and therefore command a market value far in excess of comparable transactions. Former holding Belmond Ltd. (Ticker: BEL) was an example of the latter as its hotel properties in irreplaceable locations such as in national parks were sold for valuations well in excess of any comparable properties.

Operating companies with large capital expenditures can also produce hidden assets. An asset with a substantial amount of up front capitalized spend and a long payback is extremely hard for markets to accurately value. A cursory view of the company’s financials will only show large and continuing cash outflows without looking at the eventual value accretion. Cove Street’s largest position Viasat, Inc. (Ticker: VSAT) is a prime example of this kind of hidden asset. Each satellite requires a few years of capex to fund the satellite, which then generates cash over a long period of time a portion of which is in turn put back into developing the next generation of satellites.

Buffetts
By their very nature companies that we consider to be Buffett compounders have the majority of their value off of our spreadsheets. A Buffett business has a major competitive advantage that allows it to generate high returns on incremental capital and grow relatively rapidly. As a result, a Buffett is able to compound intrinsic value.

It is extremely difficult to capture compounding—which is non-linear—using growth rates that are linear extrapolations of the present. The effect of compounding on a true Buffett will result in profits and returns far in excess of what is modelled. As a result, we are far less likely to sell a Buffett when it has reached our estimate of fair intrinsic value. Rather we humbly attempt to give a Buffett runway to compound and potentially produce a new, far higher intrinsic value.

Although spreadsheets and quantitative valuation techniques are a vital part of our tool kit, it is often the factors off the spreadsheet that are the ultimate determinants of value. Through our extensive due diligence and long hours of hard work, we do our best to better understand the variables discussed in this article. Cove Street distills the results of these efforts into our decision process which ultimately guides our investment decisions.

– Dean Pagonis, Principal + Research Analyst