An idea came to me recently that what value investing truly needs is a re-branding. Companies often re-brand and re-name themselves after some sort of failure—just to escape the taint associated with the prior name—so why not an investment philosophy? Maybe if we added the words “digital” or “software” to the name of the practice of buying cash-flowing businesses for less than they are worth, the performance of what has been unloved would improve relative to the types of companies that are now in favor. Digital value investing just sounds cooler. Or, even better would be to call what we do at Cove Street VaaS or value-investing-as-a-service. That would definitely get people to be more excited about our style of investing.
Does Value Investing Need a Rebrand?
But what would Ben Graham and Charlie Munger think of value investors trying to become more hip? Hey, if even Charlie has figured out how to use Zoom, isn’t that evidence that COVID has accelerated existing economic and consumer trends in a way that essentially kills old ways of doing business—and therefore old ways of investing? Re-branding aside, we are going to say “No” to this idea and point to the one thing that will always matter as it relates to successful investing: the price you pay. No matter how big a secular tailwind a business has, there is always a price at which the valuation no longer makes any sense. In other words, if you extrapolate 20% revenue growth for long enough, eventually that implies that the hot company in question takes 100% share of the total addressable market. Not every business is as dominant as is Google Search and any company growing that fast attracts new competition as well as a serious response from the incumbents. So, if you are paying a price that embeds 20% growth in perpetuity, you are very likely destined to be disappointed—in the long run of course. We see a lot of companies out there for which expectations are so high that anything less than perfection will likely lead to a despondent shareholder base.
Tesla, Bitcoin, and Baseball Cards
Fine, you say. Maybe Tesla and its other ridiculously valued cohorts are expensive and the go-forward return expectations for the associated securities are low or even distinctly negative. First off, that doesn’t mean that what can only be derogatorily called “traditional businesses” are going to do well in a post-pandemic world. If software is still eating the world, isn’t that a huge headwind for businesses that—gasp—actually make or distribute physical products or exist outside of the cloud? Secondly, since you can’t eat relative returns, just because U.S. value stocks may go down less when greed gives way, once again, to caution and fear, that doesn’t make them the best asset class in which to put money. Why not buy Bitcoin or emerging market stocks? Or better yet, harkening back to my teenage days when I used to sell my personal collection at physical card shows, why not invest in rapidly appreciating baseball cards instead?
Those are fair questions and ones for which the ultimate answer will only be known in hindsight. Nevertheless, we will try to provide some context for the framework we are operating within. On that note, the following is a defense of owning a highly curated, concentrated portfolio that we believe can be both an absolute and relative winner over a period of years—mainly due to the degree of margin of safety, relative to current intrinsic value, and the fact that the value per share is increasing each year.
Where there is Still “Value” in the Market
As a reminder, employing our Small Cap PLUS strategy intentionally does not generate a Ben Graham-esque, low price-to-book-value collection of stocks. We typically don’t want to own things that are cheap for a good reason but that we believe we should trade at 9x earnings per share versus 5x. Specifically, our stated goal is to buy businesses that are getting more valuable each day and avoid businesses that are definitively shrinking or have very stiff secular headwinds. Anecdotally, it is mainly the latter companies that show up on our new idea screens. Many are historically decent—or even good—businesses that are perceived to be dying, such as Deluxe Corp (Ticker: DLX) in check printing, Cimpress (Ticker: CMPR) in printed business cards, and Nielsen (Ticker: NLSN) in linear TV measurement. These stocks appear to be cheap based on trailing or near-term future cash flows. We certainly believe there could be market-beating returns to be had through investing in businesses for which the market’s perception of disintermediation is either outright wrong or just overstated. Our largest position, Lumen Technologies (Ticker: LUMN), is a stock that indeed fits that description. We admit it; Lumen is a traditional value stock that trades with such a large margin of safety that we believe it represents an incredibly compelling investment at the moment.
But in general, we strive to avoid owning deep value stocks, a nuance that makes Small Cap PLUS a little different from our Classic Value Small Cap strategy, whose lead portfolio manager has a more “eclectic” approach. In fact, the rest of the stocks in the PLUS portfolio don’t fit that mold. We own them specifically because they have competitive moats, generate high returns on capital, and will benefit from growth tailwinds that the market is currently underappreciating. While there aren’t many such companies out there (especially today), within a sea of thousands of publicly traded companies, our experience has taught us that we can (perennially) find 20 to 30 of these needles in the haystack, regardless of what the rest of the market looks like from a valuation perspective. As such, if you are an investor looking for true unicorns in today’s market, it is probably not the newly minted $1 billion valuation, unprofitable startups that you should be focused on. Given the excitement surrounding the venture capital world, those are much easier to find than are public, mispriced compounders that actually offer you liquidity and some semblance of proper corporate governance.
The Anti-Tesla Portfolio–Two Ways
Now we come to the title of this piece and a somewhat snarky observation about what we are seeing at a high level. Let’s assume you believe there is a lot of folly in the tech and growth world and thus want to bet against it. With that as a starting point, if you were a long-only investor who wanted to put together a group of holdings that essentially represented the anti-Tesla portfolio (with Tesla being the poster-child for everything that is BOTH disruptive and not particularly profitable), you could do one of two things. You could assemble a list of the obvious disruptees—think GM and Ford—across multiple industries in a contrarian bet that the incumbents may well be under pressure but that their low multiples and current valuations underestimate their staying power. That strategy would entail buying a bunch of optically cheap companies with clear secular headwinds and risks in the hope that a) the disruption narrative is wrong or b) there are enough puffs left in the cigar butt to generate a decent return. To us, that sounds like a hard way to make a living.
Alternatively, you could pay up a bit to assemble a roster of profitable, cash flow generating companies that enjoy secular tailwinds but who have two majors flaws from what we can tell.
- The first is that they do not sell software or have an aaS attached to their business model.
- Secondly, investors already know—within a certain band—what margins and revenue growth will look like over the next five years.
You see, knowing that a company has mid-20s EBITDA margins is not as compelling as is learning in the IPO prospectus what management thinks margins should look like, once the company eventually decides to focus on profitability. Similarly, it doesn’t matter if a company has an industry-leading market share and generates returns far above its cost of capital. The problem is that the business model is constrained by the pesky laws of supply and demand. Even if the underlying businesses have been growing at a moderate but consistent pace (outside of 2020 of course), they are the essentially known quantities and that, at this very moment, is just not very exciting.
On the other hand, for companies that enjoy the luxury of being perpetually unprofitable, investors have the privilege of using their vivid and expansive imaginations to assess what the glorious future will look like. Said more precisely, right now, there is a huge premium being placed on potential versus the current reality. We feel it in our bones that there is a regime-changing coming (soon?) regarding the revenue multiple—the only way to value certain companies given the dearth of profits—investors are willing to pay for hype and what could be. Accordingly, what we own by and large jibes with the second anti-Tesla portfolio: undervalued compounders that are not trying to be a battery maker, solar panel designer, auto manufacturer and data company all at once. We have bet substantial sums of our own money on the idea that, at some indeterminable point, up will no longer be down, left will no longer be right and the bird in hand will be more highly prized than what is lurking in the very distant, potentially treacherous, and maybe even non-existent bush.
Steady is the Course
Summing up, it is indeed true that some of the global macro issues out there are quite scary. And, like we have been saying for most of the last two years—outside of Q1 2020 of course—U.S. stocks are broadly and increasingly more expensive. However, we continue to love what we own and have not changed our opinion that a number of our large positions that have barely bounced off of the bottom (or not at all) are like coiled springs that could produce what we lovingly call “lumpy” returns. So, in the words of the very astute entrepreneur Jerry Maguire, “who is coming with us?” Our phone lines are open and operators are standing by.
Sincerely,
Ben Claremon
Small Cap PLUS Co-Portfolio Manager
