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What Worked in Hindsight: Buying High Valuation and/or No Earnings

We know all too well that what has worked recently is owning low-ROE and non-earning companies. But going forward, isn’t it reasonable to expect solid long-term performance from owning good businesses that trade at fair valuations and are run by people who we have determined are stealing with us, not from us? We think it is and we have a strategy that should be well situated. Specifically, Jeff Bronchick and I co-manage Cove Street Capital’s Small Cap PLUS strategy. PLUS has a SMID, quality tilt versus our Classic Value Small Cap Strategy. And, according to BlackRock, quality is on sale:

https://www.ft.com/content/472d815b-ee0b-4738-9ad7-b1d6d9ea1289

Source

Now, we recognize that “quality” is a little hard to quantify or qualify. The word can mean different things to different investors and BlackRock has its own definition of quality:

Exposure to large- and mid-cap U.S. stocks exhibiting positive fundamentals (high return on equity, stable year-over-year earnings growth, and low financial leverage)

These are fine attributes to which we would add companies that:

  1. Have historically achieved high returns on invested capital
  2. Can invest capital at high incremental rates of return
  3. Are getting more valuable each day
  4. Don’t have any clear secular headwinds
  5. Operate within industry structures that provide them with pricing power

If you are perplexed when you hear that companies with similar attributes are trading at the “biggest discount in two decades,” so are we. We know it might sound strange to know that we are pretty excited about the future, especially given all of the exuberance and lofty valuations we see in the U.S. stock market. But the quality-leaning companies in the PLUS strategy have weathered the COVID storm, are poised to bounce back with the global economy, and seemingly trade at a surprising discount to our conservative estimate of intrinsic value. Happy to discuss this with anyone else who is in disbelief.

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