A Second Life in Public Equities
Emerging from the crowded wilderness
A few years ago, when I was managing a SMID strategy at Cove Street Capital, I wrote a quarterly letter that was called The Lost in the Investing Wilderness Checklist. The backdrop of the letter was that the stocks I owned were not doing great, at least relative to the market, and my goal was to write a somewhat fun, but self-reflective piece that included a checklist of questions investors should ask when they find themselves in a tough spot. Ever since reading Atul Gawande’s book, The Checklist Manifesto, I have been a big fan of having investment checklists. At risk of mixing metaphors, I see a number of parallels between being a pilot whose flight path has taken him or her way off course and a portfolio manager whose investment theses are not playing out as anticipated—and feels as though he or she is lost in the investing wilderness. Here is an excerpt from that letter:
It goes without saying that developing a successful, long-term investing track record is hard. Not only are there behavioral biases that constantly plague you but you are also competing with other very smart and driven people who all come together to make the developed equity markets generally efficient.
And, let’s not forget that luck—or the lack thereof—often can overwhelm an investor’s skill and ability to generate unique insights. Over a long career, there will be (hopefully short-lived) periods in which you feel like you own the “wrong stocks” or that you underperform on a relative basis regardless of which way the market is trending. The last year has unfortunately felt like that for your loyal Small Cap Plus portfolio managers. What such times lead to is a fair amount of inevitable soul searching and a metaphorical wandering through the investment wilderness. It is at times like these that I like to pull out a checklist of ten questions I created to make sure I haven’t lost my investing North Star.
Think of the following as equivalent to the checklist an airline pilot goes through at the first sign of mid-air distress:
Has anything materially changed about the process by which you perform diligence on companies?
Are you now investing in a different type of company or in those slightly outside your circle of competence?
Have you become less vigilant when it comes to company balance sheets and leverage ratios?
Are you stretching when it comes to valuation? On the other hand, have you refused to pay up for better businesses?
Have you acquiesced to investing in lower quality businesses or those with secular problems because they appear “cheap”?
Are you holding onto companies not because you believe in the long-term prospects but simply because you think they are too cheap to sell?
Have you begun to take shortcuts in your decision-making? Have you been in a hurry?
Are you not sufficiently collaborating with your teammates on new and existing ideas to make sure that you have multiple perspectives on a stock?
Have you witnessed material permanent capital impairment within securities in the portfolio?
Are you indeed acting when you have true conviction?
There are probably twenty other questions that different people could add to this list, but, given my particular bugaboos and predilections, the above list is the most material and pertinent to me. I would also note that asking these questions is valuable irrespective of near-term performance. You don’t have to see a flashing warning light in order to break the proverbial glass.
A lot has happened since I created this checklist. No, the process and philosophy have not changed. The ten questions remain highly relevant and continue to inform my approach. In fact, the checklist is applicable regardless of if I am focused on public equities or private businesses. Further, my North Star it still shining bright. It is just in a slightly different corner of the sky. Specifically, over the last 15+ years I have learned a lot of lessons that have been profoundly impactful. As a result, there are now two musts within my security selection: businesses that are getting more valuable over time and have internal business momentum. The latter is a concept that captures operational excellence when it comes to execution. I learned the hard way that there are seemingly good companies with high historical returns on capital and that have ostensibly growing TAMs but are unable to compound their value due to poor execution and/or capital allocation. In hindsight, the above list should have included twelve questions, not ten, with numbers 1 and 2 having do with compounding and momentum. But the clarity I have received from the recognition of how my process could get better has been invigorating.
The other consequential change in my own perception has to do with game selection. After spending over 15 years on the public equity side, I started to question if that was the most rewarding place to spend my hours. In other words, going back to the wilderness metaphor, if I am inevitably going to get stuck in the wilderness again, what kind of trees do I want to be surrounding me?
The long listening tour
In the spring of last year, when it became clear that, after 12 years, my time at Cove Street was coming to end, I embarked on what turned out to be an enlightening listening tour of the investment industry. I talked to people all around world who invest in all kinds of different asset classes. My one ask for every single person I spoke to was to introduce me to one person in their network. No agenda. I just wanted to speak with smart investors who I could pepper with questions about the kind of opportunities that were out there, who was bringing in new assets, and what key variables I should be evaluating as I looked for a new role. What I heard from the public markets investors I spoke to was that their business models were under pressure. Fees were too high and were coming down. The number of investing seats available at these firms was either flat or declining. It didn’t matter if they had $8 billion in AUM or $100 million, almost nobody was raising money. I remarked a number of times to the people I chatted with that the mood within the public investors I spoke with was as dour as I had ever seen. People compared the fundraising environment to what it was like in 2009. What in the world was going on?
From high level, the problem is that there are simple too many people playing the same game. At almost every recent Berkshire Hathaway Annual Meeting, Buffett and Munger basically said out loud that there are too many people trying to compete by choosing individual stocks, all of whom are highly compensated and believe they are better than average. The population of Lake Wobegon had swelled to be so large that the above-average inhabitants had to fight for food and shelter. That is an especially good metaphor for what has happened within the public equities space. There are too many mouths to feed as the allocators have shifted their gaze to all things private or that offer low-fee beta. That leaves almost no space for undifferentiated firms or those who have yet to establish the kind of brands that allocators and consultants feel comfortable with. The total public equity fee pie is not growing, especially when it comes to smaller-company-focused managers, and firms without scale are suffering. Outside of a few firms I am aware of that have experienced impressive AUM growth, even the big ones are struggling to maintain their asset bases.
With all the context I gathered from my listening tour, I went about underwriting a new firm to work for similar to how I underwrite an investment. Sadly, there aren’t a lot of public investing firms that are getting more valuable every day (given all of the above) or have much internal business momentum. In fact, there are aspects of the universe that are likely in secular decline. All of these dynamics will lead to further consolidation as firms will reach for scale in an attempt the survive. The issue many firms have is that they offer a suite of legacy products that may not even be in the best vehicle for their clients. Either the fees are too high or the tax efficiency is lacking or their target customer bases are going away. In the meantime they are cash cows that continue to feed a lot of mouths.
The history of business is that the industry leaders struggle to innovate as the world changes. That is why disruption occurs so frequently. ETFs were the first major blow to the long-only equity world. Then came the rise of passive strategies that offered less volatility and impressive returns. It would be hard to argue that allocators’ perceptions of the long-only space haven’t been fundamentally transformed. With all due respect to my many friends in the public equities space—most of whom are feeling the same pressures—it felt tough for me to get excited about dedicating the next 12 years of my life to being successful in a stagnant industry. Beating the market and navigating the inevitable periods where you are lost in the wilderness is hard enough on its own. But even if you are able to achieve that, who says you are actually able to see the sunlight given the persistent headwinds?
Could the pendulum swing the other way? Back toward active vs. passive and to public vs. private? It sure hope it will happen. I am rooting for a reprieve from the hailstorm. But the experience of going through the listening tour gave me a crystal clear sense of direction. The number one question I got from people when I told them I was looking for a new role was “when are you going to start your own fund or firm?” Of course that crossed my mind. But as I was walking around the Berkshire Meeting in May of last year and came across 10 other people who run some version of a subscale, concentrated U.S. SMID quality strategy, it was really hard to make an intellectually honest case that I could differentiate myself sufficiently to create a business out of running public equity only capital for other people. At least not at this very moment when raising assets is so challenging. I simply evaluated a business model that looks like it is breaking (hopefully I am wrong about that) and thought that my skills would be more valuable in a hybrid setting where I could be a bridge between private and public equity.
The start of a new adventure
For anyone who hasn’t been following along or is new to this Substack, I detailed the strategy and approach behind my newest venture in a recent (long) post. I feel supremely lucky to have been able to share my investing journey with so many people. That process started with the Inoculated Investor blog, moved onto Cove Street’s blog and continues on this Substack and, of course, on the Compounders podcast. The lessons learned and experiences at my new firm, Devonshire Partners, are likely to be quite different from prior paths I have taken. But I am really excited to see where this new investing adventure takes me. What you can continue to expect from me is my authentic thoughts on investment process and philosophy, as well as my views on the investment management industry and the business of managing money. I hope to be able to straddle the public and private investment realms with the dual goals of being a bridge within Devonshire and of being a window for those who have not been exposed to what I am starting to see is a vast universe of potential large investments in a microcap universe that suffers from a structural lack of capital.
For anyone who is interested in learning more about Devonshire or in chatting with me about ways to take advantage of the discrepancies that exist between the private and public markets—or the blind spots that seemingly persist—please feel free to reach out. You can always reach me at bclaremon@devonshirepartners.co.
Excited for a new adventure,
Ben Claremon