We bought our Mutual Fund for $1 when we started Cove Street. It might have been overvalued on an NPV weighted for back-office commitment. This is a version of the Annual Letter that some might think is interesting reading.

As many shareholders know, the “Annual Letter” is somewhat superfluous as we write to our partners quarterly and this iteration comes so quickly after our last letter. As a result, some of this is repetitive if you think regularly reading our Letters is as fun as we might think it is. This is much more “big picture” than our quarterly letters, so we would encourage you to read the priors if you’re looking for more rigorous stock analysis.

To satisfy the regulatory gods, we would note that the CSC “Value Restoration Project” is well underway, although the same cannot per se be said for the concept of active management in what can be loosely described as “value management.” Our results have materially improved over the past two years specifically as a result of what we have specifically chosen to own, not as a result of massive flows of new capital into our space or that we have woken up as the “Chosen” asset class in the minds of global investment strategists or some talking head on CNBC. That’s the good news because we think that is still to come. But it is important to reiterate that our Fund is not an index fund which just rides tides up and down and frankly owns what we lovingly call the “nonsense du jour.”

To wit, we are paraphrasing some work – with permission – from Grants Interest Rate Observer who get some help from some very large firms who employ people with nothing better to do than relentlessly crunch macro numbers versus research actual companies. Yes, it self-servingly supports our case.

• Since year-end 2016, the Russell 2000® has lagged the S&P 500 by more than 75 percentage points, including reinvested dividends. In times gone by, a phase of small-cap underperformance would give way to a phase of small-cap outperformance, and vice versa. We proceed with the working hypothesis that the cycle will turn again.
• The crowds eventually melt away. “Of the 10 largest market cap companies in the world going back over the past 50 years, on average seven or eight of them are gone from the list within the next decade,” Rob Arnott, founder and chairman of Research Affiliates, LLC, tells me. Regarding the moniker “Magnificent Seven,” Arnott adds, “I think they haven’t watched the movie. There’s only three left living at the end.”
• Marathon Partners likes to remind its investors that larger and smaller companies have regularly jockeyed for position in the equity performance derby, with the typical bout of small- cap underperformance, excluding the current period, averaging 4.4 years. “The ongoing streak of smaller-company underperformance is one of the longest on record, and if it continues into early 2024, it will exceed the 7.3-year record established between July 1983 and October 1990.”
• Using some “adjusted math” to account for the fact that more than 30% of the Russell 2000® is unprofitable, Research Affiliates compares market segments using a broad valuation framework of price to cash flow, price to book value adjusted for intangibles, price to sales and price to the sum of dividends and buybacks. Using these metrics, the Russell 2000® today is trading at 49% of the value of the big-cap Russell 1000® index.

versus an average of 88% dating back to 1968. While discounts relative to the blue chip gauge do not, in themselves, serve as good signposts for regime change, “relative cheapness trends with pretty high odds to prevail in the long run,” says Arnott. “There is no time ever [since 1968], when small caps got below a 40% discount—not a single time— that the sector failed to win over the next five years.” The snapback can be substantial. “Our models suggest that, at this deep discount, we would expect small cap to beat large cap by 5.5% per year over the coming five years,” Arnott advises via email. “I think that might be too conservative….From this deep a discount over the past 55 years, small cap has historically beat large cap by roughly 800–2,000 basis points per annum over the subsequent five years.” This valuation gap is entirely an American phenomenon. According to Research Affiliates, smaller companies in developed markets trade at 79% of the multiple of big caps (versus a long term average of 88%) and smaller companies in emerging markets trade at 87% of the value of bigger companies (versus a long-term average of 81%).

So we suggest to Fund shareholders that not only could we benefit from decades of experience at the Fund and a disciplined investment process, but conceptually that there might be additional capital at the margin considering re-investing in small cap. And we don’t believe it will take a lot. So, again, we make the case for strong relative Fund performance specifically and small cap investing in general.

Let’s rehash some of our thinking on our two biggest losers and winners over the past 12 months. We say around Cove Street Capital: certain things can only be explained as “off spreadsheet” events. That Viasat (Ticker: VSAT) launched the first of its three satellite network flawlessly only to have a Northrup antenna fail – the first failure in 13 deployments – was not part of our investment narrative. While most costs are fully insured, the math on the actual cashflow produced by a giant increase in service capacity is pushed out to the right by at least 18 months. That is not a good thing. Now, what are the odds that Inmarsat, which recently merged into Viasat, also suffered what is likely to be a total failure after launch of its I-6 F2 satellite – the first such mishap in its 40-year history? Again, the satellite was insured for costs, but these setbacks clearly delayed a cashflow inflection point and thus decreased our present value.

Yes, we did increase our position and made Viasat our largest position prior to these launches. And yes, we sold 30% of the position in between launches to reflect a change in the time value of our money, and it became merely a “Top Ten” position. And yes, we then tax-sold our entire position which we have been carefully rebuying post the close of our fiscal year.

And yes, the stock is stupid, stupid cheap with immense strategic value in a world of “more space.” The stock wakes up every day without memory and seeks to discount the future…and thus we endeavor to analyze the future in a probabilistic way, and weight positions appropriately given the risk / return balance. We think Viasat is a very good bet from here, just not our best, highest-conviction bet. Things change.

Our other large detractor has been E.W. Scripps (Ticker: SSP) on valid concerns about the general economy and ad market, as well as the world of “strikes” which can affect the desire of auto companies to advertise and the ability to produce “scripted” television and movies. We think all these issues define “cyclical and temporary,” and we aggressively added to our stake to make this a Top 5 position. Scripps has done a very nice job of positioning itself to capitalize on the evolution of the media industry. We think “legacy” TV has much longer life to it than “fancy talk” suggests, and despite obvious exposure to the cyclicality of the advertising business at large, Scripps is a cash gusher that is rapidly paying down debt from a series of acquisitions that were enabled under the prior administration. Pick your favorite math, but ours suggests that free cashflow to pay down debt is creating 30% annualized increases in equity value at current levels. We have had different levels of exposure to SSP over the last decade – ranging from zero to our current Top 5 position. Adding to our stake has neatly rewarding us here in the last quarter of 2023.

On our two best performers over the past year we have Hallador Energy (Ticker: HNRG), which continues to perform strongly, as the inherent value in “old carbon” continues to regain some grudging appreciation in financial markets. We continue to think this is an investment with “legs” given the difficult supply/demand issues inherent in any form of a “green” transition. To reiterate, we are here to make you money in a legal and ethical fashion, not to parrot any of our own personal orthodoxy. But importantly, we continue to risk weight the stock as a classic commodity and are net sellers to maintain a 2.5% position.

Lastly we have Lifecore Biomedical (Ticker: LFCR), which remains “under wraps” in a public strategic review process being led by Morgan Stanley. We sold our common stock position near 2023 highs to risk adjust our exposure. We retained the preferred shares, which continue to pay-in-kind. We “think” we will see a reasonable outcome to be announced this calendar year. This has involved an unbelievably wide set of variables in our investment process where we properly identified an extremely valuable set of assets hiding in a public company but completely misunderstood just how ill-suited and awful a management structure can be.

In closing, we thought we would reiterate some of the “core thoughts” about how we approach investing. Repetition is good in investing as there is a LOT of silly distraction.

We are classic value investors in the tradition of Benjamin Graham and Warren Buffett, seeking superior long-term performance through the purchase of securities selling at prices materially below our estimate of intrinsic value. This process of “winning by not losing” protects capital from permanent loss (as distinguished from “quotational risk”) and puts us on the correct side of the mathematics of compounding.

We believe the best performance records in the investment industry have been created by small teams of value-based analysts, as decisions are made by those doing the actual research. Cove Street Capital’s work and time are not wasted through committees and laborious people management processes.

We run concentrated portfolios, which allows our best ideas to drive performance. It is both a fool’s errand as well as disingenuous to clients to over-diversify the results of careful decision-making in an attempt to mimic indices to achieve performance. The only way to achieve superior long-term returns is to have the intellectual courage to differ from the mood of the day and the indices to which we are compared.

While we hunger for objective evidence and rigorously model our investment ideas, we retain a healthy skepticism toward advanced math and formulaic convention. We are investing in real businesses run by real people whose securities are valued in the short-run through an imprecise prism into a future that is always uncertain. There will never be a precise formula for good judgment.

To paraphrase Buffett paraphrasing Graham, we will neither be right nor wrong because the crowd disagrees with us. We will be right when our data and reasoning are right.

Despite a tremendous amount of academic and practical effort, financial markets are only “occasionally efficient.” We believe even the most cursory review of market movements over the past two decades renders any other conclusion unsupportable by common sense.

Pricing inefficiencies systemically exist in the market place due to a variety of factors. Many are due to the “business” of money management, which encourages a myopic focus on short-term phenomena – quarterly earnings, news chasing, quarterly performance reporting – that are inherently and historically unpredictable. This limited scope produces opportunities for investors who have the discipline and confidence to invest with a longer-term time horizon.

Another issue relates to asset size. It is simply impossible to understand with any depth 400 companies in a portfolio; conversely, a fairly concentrated portfolio with a reasonable asset size enables in-depth fundamental research to add value as well as the enhancement of the ability to recognize mistakes and make changes.

Finally, value investing – the art of buying a dollar for 60 cents – is not easy in practice. It requires discipline and patience, attributes that have proven not to be innate to members of the institutional money management world. Whatever the asset class, value-oriented investing remains the only intellectually viable investment philosophy that not only makes common sense, but also has a track record that has stood the test of time.

We again appreciate your partnership. We reiterate our focus on “there is less new today under the sun than is commonly surmised.” Our companies have seen rhyming versions of recessions, inflation and deflation, horrendous government policy mistakes, geopolitical wackiness and any variety of “off- spreadsheet” events that have to be dealt with. We are starting to see a wide swathe of opportunity, but recognize that events outside our control may conspire to delay gratification. Our contention and research suggest that we own businesses that have growing intrinsic value at reasonable valuations and thus market turmoil is more likely to be mostly short-term “marks” rather than a permanent capital loss. And thus opportunities for future wealth creation.

That is what we think we own today.