In case we haven’t said it enough in the past, we own 20-something stocks in our Small Cap PLUS portfolio and as the name would suggest, the Russell 2500™ has approximately 2,500 securities. By definition and by design, the performance of a concentrated portfolio is unlikely to look anything like what a portfolio with thousands of stocks looks like over any particular 12-month period. Having said that, for our absolute and relative performance to stand out, we need our largest positions to deliver on closing the gap between the current stock prices and our assessments of intrinsic value. While timing is always hard to predict and investors should expect somewhat lumpy returns, our ongoing, detailed research into our most important positions gives us a lot of comfort and provides conviction that this portfolio is incredibly well-positioned for the next few years.
An obvious question to ask after reading the previous statement is: how can you be so confident that this eclectic mix of securities has the potential to outperform in the coming years? That question ties in directly to the topic—and the title—of this letter. I was recently listening to an investing podcast where the erudite guest said something to the effect of, “Being a good investor requires an equal amount of arrogance and humility.” While that may sound like a contradiction, or simply an impossible tightrope to walk, in my humble opinion, humility and arrogance play off each other in a way that doesn’t require an investor to live in a constant state of cognitive dissonance.
Indeed, to be really successful, you have to be confident (a word I much prefer to arrogant) that your analysis and decision-making are best-in-class. You also need to embrace your contrarian perceptions and be somewhat unflinching in your assertion that the market is wrong. Why? Because the market is going to tell you in a thousand different ways that you should give up. It will punish the stocks you already thought were undervalued based on no obvious catalyst or new information. Even Amazon.com Inc. (Ticker: AMZN) and Apple Inc. (Ticker: AAPL) have seen 70%-plus drawdowns over the years and it takes a fair amount of conviction to hold—or even buy more—during these inevitable stock-specific recessions.
On the other hand, you have to be humble enough to recognize that maybe YOU are wrong and that there are potential outcomes that you can’t possibly predict or handicap. So many young analysts believe that all the answers lie on their color-coded spreadsheet. But, as Paul Black, the founder of $105 billion asset manager WCM recently said on a podcast, people relying on a DCF is his biggest investing pet peeve. Many things that you can’t possibly model accurately can, and will, happen. Investors need to simultaneously believe they are right and exhibit the humility to question their own premises and admit when they are wrong. And it is that self-awareness and the desire not to make a meaningful error of omission or commission that must drive and inform your due diligence and decision-making process. In that way, the two traits actually feed off of one another. Humility pushes you to work harder and dig deeper—and that knowledge accumulation makes you more confident in your conclusions.
So, with all of that as a backdrop, I thought it would be instructive to go through the contrarian perceptions we are confident about as it relates to the top three positions that make up more than 25% of this portfolio, as well as the variables and uncertainties that keep us grounded and humble. Then, at the end, we will discuss the North Star that we think allows us to be both humble and confident at the same time.
Contrarian Perception #1
The value of the Lumen Technologies’ (Ticker: LUMN) assets far exceeds the current enterprise value and, maybe even more importantly, the management team knows how to realize that value. This is a topic we have discussed on a number of podcasts, so we won’t rehash the whole thesis here. But, our research and the recent moves by the company continue to overwhelmingly suggest that the management team is focused on highlighting the value of its fiber assets and would prefer to be a B2B company—not a consumer broadband company. Private market multiples for fiber assets continue to be very attractive, especially relative to the valuations LUMN trades at. As such, our conservative sum-of-the-parts analysis implies a mid-$20s stock, with upside if the company is able to get a comparable multiple for the fiber assets. The two divestitures that were signed in 2021 should close in 2022, and the company will have the management bandwidth to continue to pursue value maximizing endeavors. Our experience with CEO Jeff Storey suggests he is an Outsider CEO while the market believes he is just another schmo stuck with a declining legacy business. We should know a lot more about which perception is accurate by the end of 2022.
Contrarian Perception #2
Viasat Inc. (Ticker: VSAT) can successfully launch its new Viasat-3 satellites within the next few years and that alone will be an enormous catalyst for cash flow generation for the company. This is another topic we have discussed over and over again. The market sees SpaceX launching satellites and Starlink offering high download/upload speeds to its very small number of users and thus concludes that Viasat is toast. It will just be another company that the infallible Mr. Musk leaves in his wake. We could write an entire letter on this subject, but we will be brief. We are constantly searching for disconfirming information but nothing has dissuaded us from the following conclusions:
• Satellite broadband will not be a winner-take-all market. (Please see the Compounders podcast interview with VSAT CEO Mark Dankberg if you want to understand the technical reasons that is the case.)
• Viasat has a very large opportunity in in-flight WiFi and military applications that will take up a lot of the bandwidth of the three new satellites, thus making consumer broadband (and competition with SpaceX) not as meaningful.
• If the previous two points are correct, then VSAT is going to hit a meaningful cash flow inflection point in the coming years.
• Lastly, it may be 100% accurate to say that the company should not be paying as much—in its own shares—to acquire Inmarsat. But that does not mean the deal doesn’t make financial and strategic sense. We would just have preferred the company embed a larger margin of safety.
Contrarian Perception #3
John Malone and his team at Liberty Media are some of the most sophisticated structurers of deals in the world and will find a way to close the gap between the value of Liberty SiriusXM (Ticker: LSXMA) and the value of the company’s stake in SiriusXM Holdings (Ticker: SIRI). Liberty SiriusXM is a tracking stock whose primary assets are large stakes in SIRI and Live Nation Entertainment (Ticker: LYV). However, the stock has consistently been valued at a large discount to what those stakes are worth in the public market. The implication is the market believes that Liberty will have to pay taxes at some point on the gains embedded in these positions. For those who may not be familiar with one of the greatest deals in recent history, Liberty acquired what would turn into a controlling stake in SIRI in 2009, during the depths of the financial crisis, for less than $1 billion. Liberty has not put in any material capital since then and now owns close to 80% of a $25.7 billion market cap company. Given Liberty’s low basis, there would be a huge tax bill to pay if the shares were sold outright. Of course, anyone familiar with Liberty knows that the people there are violently allergic to paying taxes and therefore will work tirelessly to find a way to merge SIRI and LSXMA in a manner that does not trigger a tax bill. Now, it may not be quite as easy as it sounds and the timing of Liberty closing the gap is uncertain. But, there were some important events in 2021 that suggest we might be getting closer to a resolution. In the meantime, SiriusXM continues to add subs and generate an enormous amount of free cash flow that is being used to reduce the public share count—and make Liberty’s stake even larger.
What keeps us humble #1 (LUMN)
There are a lot of moving pieces at LUMN but there is a definitive issue that the business as a whole is not growing. COVID has had an impact on the ability to win new business but COVID is not to blame for the consistent declines that LUMN is seeing in a number of legacy business lines. So, there is melting ice cube risk here and it is hard to equate someone paying a high multiple for LUMN’s fiber assets with a shrinking business. We recognize that at some point the investments the company has been making in what I would call the future of the internet (such as facilitating edge computing and internet of things (IoT) applications) are likely to lead to growth and that the shrinking pieces will eventually be so small that they no longer are meaningful detractors. But, that growth inflection point might still be years off and there is a real risk that there is no way to monetize fiber assets until that point is reached. In the meantime, we will be watching for signs of life in the parts of the portfolio that have growth opportunities and urging management to consider a structure that separates the B2B side from the consumer business.
What keeps us humble #2 (VSAT)
This is an easy one. The media, other investors, and random Tesla bros on Twitter remind us frequently that Starlink is a force to be reckoned with and that many have fallen when trying to compete with the mighty Elon. As such, we constantly monitor the evolving competitive threat posed by low-earth-orbit (LEO) satellites providers. In addition, we recognize there is a fair amount of technological and commercial execution risk associated with Viasat launching new satellites that offer speeds no other geostationary satellites have ever produced and then selling that bandwidth to governments, airlines and consumers around the world. So, there is a lot that Viasat needs to do right over the next three years, including the integration of Inmarsat, the company’s largest acquisition in history. No one should discount how hard it will be to do all of these things well simultaneously.
What keeps us humble #3 (LSXMA)
Since Cove Street was founded, we have often operated under the mantra “In Liberty (Media) We Trust.” We have an enormous amount of faith in the ability of the people at Liberty to create value for the shareholders of the various companies under the umbrella. However, we are not experts on the nuances of the U.S. tax code to the degree that we can for certain say that LSXMA and SIRI will be able to merge in a tax-free transaction. And since it hasn’t happened yet and the LSXMA valuation gap persists, maybe the task is too Herculean for even the Liberty tax sleuths. Plus, let’s not forget that SiriusXM specifically has to continue to perform, despite increasing competition from Spotify and other music streaming services. Another thing we often hear is that young people don’t listen to satellite radio—or Pandora for that matter. All the cool kids listen to Spotify or get their music from TikTok. SiriusXM is most certainly focused on attracting millennials and Gen-Zs to its various platforms but there is certainly a risk that the subscriber base starts to shrink over the next decade.
What keeps us humble #4 (LUMN+VSAT+SIRI)
Just to point out the common theme regarding the companies we are highlighting, we own three highly capital-intensive businesses that provide communication services to consumers and businesses. While these businesses do not compete directly in a meaningful way, there could be some “beta” risk of owning all of the above. More precisely, despite the fact that the value creation path is very different for all three, at least in the short run there is a risk that the entire Communications Services sector within the S&P falls out of favor. While that outcome would not necessarily impact the intrinsic value of our companies, when you have more than 25% of your portfolio tied to that sector, a sentiment change would not be fun to live through. This concern does not consume us, but we do want to be conscious of industry concentrations within the portfolio.
On that note, we should mention that we are certainly not TMT-focused investors. This is quite simply an area where we are finding a lot of value and companies with idiosyncratic, actionable paths to closing the gap between the market value and what our work suggests they are worth. To achieve great success in investing, my belief is that you need to be willing to think differently and take big swings when you see hanging curveballs. Otherwise, why wouldn’t our clients simply buy an index?
What brings this all together
In reflecting on how it is possible that investors successfully exhibit high levels of conviction and humility simultaneously, it struck me that there might be one overarching element that makes it work. Specifically, what gives me the ability to a) sleep at night and b) have enough conviction to believe a portfolio can outperform, is margin of safety. Stocks trading at extreme discounts to intrinsic value protects you from a lot of negative things. Of course, being arrogant and blind to disconfirming information is never a good combination. It is also not a smart idea to be arrogant enough to believe you can accurately predict the future of any company and that is especially true if the stock price already reflects elevated expectations and perfect execution.
On the flip side, you can feel a lot more comfortable with large position sizes and contrarian perceptions when you have a significant margin of safety to work with. And we see that throughout this portfolio. Looking up and down the list, I mostly see “people would really care if this company went away” companies that are underappreciated for some reason and have catalysts to create value for shareholders. We are not relying on already loved and expensive (at least relative to historical metrics) companies doing even better than the market expects. That “companies can grow to the sky” strategy has worked really well for the last few years. But, here’s to 2022 being a year when value investing, margin of safety, cash flows, and “quality” businesses become important to the investment community again.
Ben Claremon
Principal & Portfolio Manager
