December 2020 Strategy Letter - Soufflés and Sledgehammers

As we have noted previously, one cannot practically ignore the celebration regarding our annual lap around the sun, although I think it’s fair to say that there are roughly 7.5 billion people outside of Silicon Valley—or those who run large cap growth/tech funds—that are delighted to see 2020 declared over.

But people, business models, global issues, and viruses tend to generally pick up where they left off on most December 31sts, so the annual version of our Strategy Letter tends to be more fluid than are most. This space is generally dedicated toward “bigger thoughts” while the CSC blog has been branching out to focus more on specific ideas, and we would encourage all to sign up.

Do we really have to go through another soliloquy on the folly of “forecasting?” (If you need a hint on what we think of the annual prediction rigmarole, we sent many of you Phillip Tetlock’s book, Superforecasting: The Art and Science of Prediction—a few years ago as a holiday gift.) Spoiler alert: it’s hard to be right and it is usually embarrassing. In fact, there is an awful lot of common sense regarding a life and an investment view that suggests adopting a baseline case that assumes the next year will be “sort of like the last 20 years, but that you need to be on your toes and looking for disconfirming evidence.” (Or a global pandemic.) Is it not odd that investing today has the contradiction that stocks are pricing in a “new era”, yet investment turnover is higher than ever and thus investors seem to have a lack of will to see their predictions through?

Overall, we start with a baseline that stocks have positive returns 65%-ish of the time on an annual basis, that the economy sort of grows in the 2.5% range, that we are not always 94% consumed by thoughts of pestilence and death, and that the present level of alcohol consumption is likely unsustainable. And that most business models and companies providing somewhat essential products, and not grossly over-encumbered by debt, are likely to “bugger on” in the words of Winston Churchill. We then make a mental note to shade our baseline for the possibility that we might be in one of two extreme cycle positions (things are generally awful and cheap, or things are good and expensive) based upon decades of reasonable historical research and thus shade accordingly. Eat and drink reasonably, get sleep, and have an investment process that can maintain some sense of rational balance in the face of “absolutely crazy things that cannot possibly be modeled on a spreadsheet.”

I have been told I should start thinking of summing up all thoughts in 140 characters if I want anyone under 60 to read Cove Street Capital output. So, let’s get directly to a few thoughts for 2021 before thinking a little deeper about the past year.

  • Most investments in most asset classes are “highly valued” by any measure that uses anything but a 1% interest rate as its hurdle rate. We repeat the idea (despite the fact that it has been incorrect for some time) that it does not take much to knock something off a high step ladder. But as consistently proven over the last number of years, a 1% hurdle is a low bar and is a powerful motivation for putting money to work in apparently nearly anything.
  • While we will discuss this in further detail below, there has rarely been a more obvious, career-threatening/don’t want to be first-mover investment opportunity in my career. Specifically, right now is the time to employ a strategy that leans as hard as one can against “large cap/growth/tech/private company in all the above” and leans into “basic cash flowing—often small cap—businesses that publicly trade.” (AKA: Smaller Cap Value.) As noted above, putting a finger on an absolute return number for any given year, or two, is a game you fail simply by entering. But, what about a relative return call? All day right here. While we don’t “idealize” one month of massive changes in relative performance (although we will take it), we do think this is a multi-year comeuppance. There is simply a planet-sized gap in trailing—and future—relative returns between what has been hot and what has been forgotten.
  • We have a disciplined, patient process, we pay attention, and we are smarter than we were last year. As such, we firmly believe there will be things to do that we can’t pretend to have our finger on right now. There are literally several hundred new public companies that have become public in a world of near nonsense or zero adult supervision. Disappointment breeds in these waters and represents a new well of future ideas.
  • The world of COVID “brain” will continue to recede. We are not negating the individual losses that are targeted sadness, but in the comprehensive historical review of global decision making, 2020 will rank as a more man-made tragedy than the tragic inflection point for mankind. The collective “we” are not changing remotely as fast as the world can blog. Endlessly. At all hours. While we lost money and faith in “cyclical vs secular” in the case of movie theaters, having exposure to a return to social interaction is a bet that will pay off.
  • What comes to mind when you think of low interest rates, seemingly unlimited and unencumbered credit, a revival of vaccine-induced human spirits, and a corporate cash flow high? M&A. Hopefully expensive, record-setting multiple M&A focused on smaller companies where strategic synergies are plentiful and corporate costs can be eliminated. We have a list of legitimate targets if you are a CEO lacking initiative and imagination.