The following is an excerpt from our Q3 2020 Small Cap Plus letter. If you have ever found yourself struggling to explain why, in the short-run, your portfolio is not behaving the way you would hope and expect, this piece is for you!

The “Lost in the Investing Wilderness” Checklist 

It goes without saying that developing a successful, long-term investing track record is hard. Not only are there behavioral biases that constantly plague you but you are also competing with other very smart and driven people who all come together to make the developed equity markets generally efficient.

And, let’s not forget that luck—or the lack thereof—often can overwhelm an investor’s skill and ability to generate unique insights. Over a long career, there will be (hopefully short-lived) periods in which you feel like you own the “wrong stocks” or that you underperform on a relative basis regardless of which way the market is trending. The last year has unfortunately felt like that for your loyal Small Cap Plus portfolio managers. What such times lead to is a fair amount of inevitable soul searching and a metaphorical wandering through the investment wilderness. It is at times like these that I like to pull out a checklist of ten questions I created to make sure I haven’t lost my investing North Star.

Think of the following as equivalent to the checklist an airline pilot goes through at the first sign of mid-air distress:

1. Has anything materially changed about the process by which you perform diligence on companies?
2. Are you now investing in a different type of company or in those slightly outside your circle of competence?
3. Have you become less vigilant when it comes to company balance sheets and leverage ratios?
4. Are you stretching when it comes to valuation? On the other hand, have you refused to pay up for better businesses?
5. Have you acquiesced to investing in lower quality businesses or those with secular problems because they appear “cheap”?
6. Are you holding onto companies not because you believe in the long-term prospects but simply because you think they are too cheap to sell?
7. Have you begun to take shortcuts in your decision-making? Have you been in a hurry?
8. Are you not sufficiently collaborating with your teammates on new and existing ideas to make sure that you have multiple perspectives on a stock?
9. Have you witnessed material permanent capital impairment within securities in the portfolio?
10. Are you indeed acting when you have true conviction?

There are probably twenty other questions that different people could add to this list, but, given my particular bugaboos and predilections, the above list is the most material and pertinent to me. I would also note that asking these questions is valuable irrespective of near-term performance. You don’t have to see a flashing warning light in order to break the proverbial glass.

Now, getting back to list, where do we stand? My answer to each is: No, No—ten times No. Well, if we are being honest and sufficiently self-critical, it should by nine times No. As discussed in last quarter’s letter, in hindsight we did not act aggressively enough during March and April even when we did have conviction. We clearly can’t go back to that time period but we can let those few weeks serve as a constant reminder that, if we have done proper diligence on a company, a market environment like we had in late Q1 is a gift that you only receive if you act. But, as for the rest of the questions, the answers are definitively No.

So, upon concluding that our investment process is not broken, that we have not changed our stripes and that it is unlikely that our investing mojo has vanished for good, what are we left with? Only that the short-term voting mechanism of the market is indicating that we are wrong in favoring the businesses we own. This is where I want to focus in on question #9 from above. The Russell 2500^® Value index and our portfolio remain down on a year-to-date and trailing twelve-month basis. As such, it is fair to ask the question: are our stocks down because there has been a meaningful decline in intrinsic value since we originally made our investment or is it just the stock price that has fallen? We would vociferously argue that it is the latter. In fact, we have been pleasantly surprised—almost shocked—at how well our companies have handled the pandemic from an operational and fundamentals standpoint. They have continued to—by and large—become more valuable in spite of the unequivocal short-term headwinds.

Our issue frankly is that a number of our largest positions have been crushed (a technical term) and have not enjoyed the rapid recovery many other stocks have witnessed. In fact, when we are looking for reasons that our performance over the last twelve months has not been up to our standards, our analysis begins and ends with Mr. Market’s distaste for Millicom International Cellular (Ticker: TIGO), ViaSat (Ticker: VSAT) and Lumen Technologies (Ticker: LUMN; formerly CenturyLink). Accordingly, before going into the quarter’s contributors and detractors, we are going to make the case that it is indeed the stock prices of these three fine companies that are totally out of line with reality—as opposed to our own inability to properly diligence and value companies.

TIGO — As we have discussed at length in prior letters, Millicom International Cellular is a provider of broadband and wireless services, primarily to people in Latin and South America. These markets are characterized by growing populations, an increasing number of people in the middle class and under-penetration of home broadband connections and data intensive wireless plans. Therefore, over the medium term, Millicom should be in a unique opportunity to grow, especially given that it has a leading positions—either #1 or #2—in the majority of its markets. The current issue of course is COVID and the things that governments are doing to stop the spread of the virus. Prior to the outbreak the company was on a path to have its recurring fixed (mainly broadband) revenues exceed its wireless revenue, an outcome that should help improve the multiple that people are willing to pay for the shares. (In general, companies that generate a higher percentage of revenue from fixed sources trade at higher multiples than do pure play wireless companies.) Obviously, COVID has not helped that process, but the essential nature of broadband and wireless services, in conjunction with TIGO’s market share, position the company very well for the future. In the meantime, TIGO is not over-levered and has the ability to generate cash. While the stock rebounded nicely during Q3 and was actually one of our top contributors, it still trades at a fraction of our estimate of intrinsic value.

• Market’s Bearish Perception: Millicom is a not a broadband company but a wireless-dependent telco that operates in up and down emerging markets that have volatile currencies and will not be able to sustain economic growth and prosperity.
• Cove Street Variant Perception: Millicom generates high margins through leading positions in attractive, growing markets and is run by a first-class management team that knows how to navigate within these countries’ idiosyncrasies. Therefore, time is our friend and the true value of what this management team has assembled and built will soon become much clearer.

VSAT — We have spent considerable time discussing our investment in ViaSat on podcasts, in strategy letters and via presentations on our website. As such, we are not going to rehash all of those points here. (Please check out CoveStreetCapital.com/Thoughts/ for MUCH more.) Very simply, our extensive and continuous research suggests that the value of the ViaSat defense business by itself is much higher than is the current enterprise value. That means that at this price you are getting the two other segments—and what will likely be the fastest and lowest cost GLOBAL satellite broadband network—for free. Either the investing world has gone crazy—as implied by ViaSat’s stock price—by narrowly focusing on what Elon Musk is doing with SpaceX/Starlink or Mark Dankberg and the ViaSat team are wrong about everything they have been planning and executing on for decades. We think it is the former and thus the next three to five years are likely to be incredibly prosperous for current VSAT shareholders. We took advantage of the fact that VSAT was down during Q3 (and was one of our larger detractors during this period) and increased our position size. Getting back to acting when we have conviction, VSAT now represents a 7.5% weighting in the portfolio.

• Market’s Bearish Perception: Elon Musk is going to dominate satellite broadband through Starlink and there is no room for ViaSat to fill up its existing, in-progress and planned satellites.
• Cove Street Variant Perception: Starlink has an unproven technology that has a ton of issues that limit how many satellites it can launch and the number of users it can serve. However, our contrarian thesis mainly revolves around the idea that competition is not the key variable. Even if Starlink is successful, there are still so many applications for ViaSat’s fast broadband, especially within the military, that it can win regardless of what the competition is hoping, or perhaps praying, it can achieve.

LUMN (formerly CTL) — Lumen Technologies is the new name of what is the combination of CenturyLink and Level 3 Communications. To say the least, the 2017 merger has not worked out as the old CenturyLink management team had planned, and the new team is doing everything it can to distance itself from the legacy telco image and brand. There is no question that there are shrinking business lines within this portfolio of assets, especially within the CenturyLink footprint. However, the Level 3 side owns some of the most unique and irreplaceable fiber assets in the entire world. And, in a post COVID world, the companies that rely on Level 3 are only likely to need its services more in the future. So, if anything, these assets have become more valuable over the last six months while the stock price has languished.

• Market’s Bearish Perception: LUMN is a melting ice cube that has too much debt and cannot grow—and therefore trades at a multiple that only secularly challenged businesses receive.
• Cove Street Variant Perception: The move to create Lumen Technologies is the first public step toward formally separating the Level 3 assets from CenturyLink’s legacy business. The consumer business from CenturyLink is indeed a shrinking business but similar businesses (Cincinnati Bell, for example) have gone for multiples much higher than those ascribed to all of LUMN: 4.7x LTM EBITDA. In addition, a Morgan Stanley Infrastructure Fund just paid almost 15x trailing EBITDA for 50% of Altice’s (Ticker: ATUS) fiber business. While neither of these deals necessarily represent perfect comps, the implication of recent transactions is that the sum-of-the-parts value for the two pieces of LUMN is materially higher than is the stock price. Our research indicates that the seasoned management team—with whom we have invested in the past—is absolutely focused on creating value for shareholders and has already begun the process.

Before we finish up, we would like to note that while all three of the companies appear to offer similar services, there is very little overlap and competition. LUMN—through the Level 3 business—is primarily a provider of broadband connectivity and other services to large, multi-national businesses. TIGO mostly provides wireless, TV and broadband solutions to consumers in Latin and South America. And, ViaSat is really focused on in-flight Wi-Fi, defense end markets, and rural consumers who don’t have access to the products sold by TIGO and LUMN. Having said that, there are a few important, common elements among these companies that we hope give our investors some solace despite the rough patch when it comes to their respective stocks:

• Leading market positions and/or differentiated technologies
• Essential businesses with high barriers to entry
• Good, if not great, management teams that are focused on the long-run value creation—and who publicly acknowledge the undervaluation of the stock
• Cash generative businesses with good enough balance sheets that can withstand short-term pain
• An asset base or mix of businesses that is totally underappreciated by the market

While this is not a foolproof set of attributes, we would humbly submit that stocks with this set of characteristics have the potential to meaningfully outperform—assuming an investor and his or her clients have the requisite amount of patience.

Sincerely,

Ben Claremon, Principal + Portfolio Manager