Patience is not a virtue that is developed easily, especially if your primary job is to assemble portfolios of publicly traded equities. The amount of short-term-oriented noise that surrounds companies, and the stock markets as whole, makes it very difficult to invest with a seven-year outlook (our preferred timeframe) or determine if there are any true signals within the noise. Our sense is that most CNBC headlines are nothing more than noise, mainly because the intrinsic value of established businesses changes slowly over time. The cacophony that we hear from the financial press is exacerbated by the quarterly earnings rigmarole and the fact that most CEOs’ stock options are likely to expire worthless if they are not able to please Wall Street within a timeframe most often measured in months. If you are an asset manager or run a public company and you take your cues from this nonsense, good luck investing for the long term.

In theory, the antidote to this unhealthy focus on what is going to happen next quarter or even next year is to create a firm culture and decision-making process that insulates the participants from being unduly swayed by the noise that triggers the common behavioral biases that plague all humans. Easier said than done. People have to either be born with—or develop over time—a temperament that allows them to truly ignore afflictions such as loss aversion, FOMO (fear-of-missing-out for those of you who are not Gen Zs), and career risk when making important decisions. The biology is not that hard to understand: stress causes you to release cortisol and a number of studies suggest that higher levels of stress and cortisol can lead to riskier and/or poor decision-making. In other words, when we see a piece of company news that causes our innate “fight or flight” response to kick in, any reactive decision we make is most likely not to the benefit our investors.

Now, if you are waiting for a silver bullet answer as to how to overcome all of the above, we hate to break it to you, but there isn’t one. It requires a murky cocktail of culture, process, temperament, client base, contrarianism, awareness and constant work to have even a chance to exhibit the kind of patience that is required to take advantage of the evergreen opportunities to profit from time arbitrage. Cove Street’s investment process is designed specifically to slow our decision-making down and focus the analysts on the long term. We are OK being the tortoise and not the hare.

The reason the topic of patience is especially pertinent today is that the world is awash with temptations. Not to get too much into the macro, but there is no question that super low, even negative, interest rates are distorting the capital allocation process. If you lower the weighted average cost of capital in all of your models to 5%, then everything looks cheap. More broadly, humans prefer instant gratification and thus, in the context of financial markets, we stretch for yield, get really excited when we see the first dip and encourage companies to maximize short-term results at the expense of the sustainability of the business model. So it goes. We don’t expect this to change any time soon, and that is why companies and investors who are able establish a time horizon that extends past what they are having for lunch can be successful over time.

But, we must not forget that when determining what constitutes success, the timeframe REALLY matters. There is an old saying that relates to value investing that goes something like: there is a fine line between being early and being wrong. Being early is when you own a stock for 5 years and it does nothing—until one day it is bought out for 2x your cost basis. Being wrong is when the client fires you in year 4. Investing with a multi-year outlook only works if you are transparent with clients from the outset, expectations are aligned and you maintain openness, particularly during those unavoidable periods when you look silly relative to the market–or even to some of your peers. All that being said, there is an inflection point at which too much patience becomes self-defeating and career threatening.

An outside critic might argue that our trading activity (or lack thereof) during the freefall in stocks that occurred during the fourth quarter of 2018 and the very beginning of the first quarter this year would illustrate that point quite well. In reality, we did not make many changes in the portfolio—we simply bought more of what we owned. In terms of new ideas, what we really needed was two more weeks of rampant fear within financial markets for us to be able to take advantage of some interesting valuations that were emerging. Alas, greed overtook fear and margins of safety quickly disappeared. Were we too patient? Only time will tell. Shouldn’t we have a deep bench of securities we can buy at a moment’s notice? We absolutely have a “Buffett list.” However, for better or worse, often times even companies that we have worked on extensively require more than a day’s worth of diligence before they are allowed to enter the portfolio.

In fact, we sincerely believe that it is a very good thing that Cove Street is not set up to be a “high frequency” trading shop. Instead, we are structured to invest in our version of what late economist Jack Treynor called “slow ideas ,” ones that require a lot of thought, understanding of context, and sound judgement. We are humble enough to know that we will never be able to predict a market downturn or a recession. But, with thoughtful research we should be able to have a sense of what today’s valuations reflect about the market’s expectations for what the future will hold.

All of this brings us back to patience. It is true that we abhor frenetic activity and unnecessary turnover and therefore we are uniquely unsuited to jump in headfirst just because stocks are temporarily in a “bear market.” But, how do you know when to act? Perhaps the best way to gauge how active you should be—within the context of being a fiduciary of other people’s money—is to use valuation as your North Star. If you put the recent little stock hiccup into historical context, even with the drop, the Shiller PE Ratio never fell below 28x—a number that is 10-plus turns above the long-term average and median. What we still see is an expensive market and generally rosy extrapolations that assume revenue growth and margin expansion will continue unabated. Down does not necessarily mean cheap. Similarly, a 20% drop in altitude when you are flying 30,000 feet above sea level doesn’t even get you to a place where humans can breathe normally (about 8,000 feet if memory serves). Our saving grace—or oxygen mask—is that we run concentrated portfolios and therefore we only need a few of stocks to fall out of the sky per year.

So, we continue to fish in attractive ponds and to focus on simple ideas. There are plenty of ostensibly cheap stocks that will be multi-baggers if a sequence of unrelated but highly impactful events plays out exactly as management hopes. Of course, if the outside world doesn’t cooperate exactly the way the company’s PowerPoint presentation posits, you had better be prepared for turbulence. Those stocks are easy for us to throw in the “too hard bin.” On the contrary, we are looking for companies that have a clear line of sight to success and do not have to jump through lots of hoops. Additionally, we have a list of companies for which there may be a way to exploit a potential time arbitrage. These are businesses that are unequivocally getting more valuable every day, have the ability to re-invest internally at high rates of return and are likely to be much larger in seven years. (There’s that number again.) Companies with these characteristics often trade at nosebleed multiples but, at times, short-term noise that comes in the form of cyclical pressures and analyst downgrades provides us opportunities to pay a more reasonable price. The arbitrage opportunity arises when the market becomes maniacally obsessed with what the company will earn over the next twelve months and ignores the long-term opportunities that exist when great management is combined with secular tailwinds.

Our unwavering strategy remains in place: we wait and when we do act, we try not to be too early and only invest only when we see a large margin of safety. This is indeed not an exciting strategy. We were recently told by an advisor that our strategy is not sexy enough for her family office clients. What were her clients interested in you ask? Bitcoin in 2018, cannabis stocks/start-ups in 2019, an as-yet-identified new “asset class” in 2020. So be it. We will happily stick to boring old value investing and look forward to the day that mean reversion causes our disciplined, long-term strategy to be a little more—but not too much—in favor.

– Ben Claremon

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