Top

General

Q. Cove Street is...where?
A. 97 Cove Street, New Bedford Massachusetts was the original corporate headquarters for Berkshire Hathaway, which became Warren Buffett's investment and business vehicle after the winding down of his original investment partnership. With all appropriate modesty, we directionally embrace the principles of value investing, high integrity, and honest and forthright communications with clients, but are highly unlikely to make any material investments in textile mills.
Q. Where are your offices?
A. Cove Street Capital moved to a new location in September 2014 — 2101 East El Segundo Boulevard, Suite 302, El Segundo, CA 90245. El Segundo is in the "South Bay" of Los Angeles, and we are 10 minutes away from LAX and under a mile from the 405 Freeway.
Call us at: 424-221-5897
Fax us at: 424-221-5888
Email us at:
Q. Who owns your firm?
A. We are 100% employee-owned. Jeffrey Bronchick and Daniele Beasley are the founders and the current equity partners. Our long-term ownership philosophy is to intelligently distribute equity to both investment and operations personnel and own less of a much more valuable firm.
Q. What about legal and regulatory?
A. We are an SEC registered investment advisor and all parts of our ADV are available upon request. (Download here: ADV Part I / ADV Part 2A / ADV Part 2B / Privacy Policy).

We have all appropriate E+O, D+O and ERISA fidelity bond coverage.
Top

Firm Overview

Q. Please provide a brief history of the organization.
A. Cove Street Capital, LLC is an SEC registered investment advisor founded by veteran value investor, Jeffrey Bronchick, CFA.

We manage assets for a global mix of institutions and high net worth individuals on a separate account, mutual fund, and sub-advisory basis, utilizing a research intensive, concentrated value-based strategy.

We are continually improving a world-class investment organization that delights clients with excellence in performance and client service, and inspires colleagues with a collegial meritocracy that rewards intellect and ambition.

Our name stems from 97 Cove Street, New Bedford Massachusetts, the original home of Berkshire Hathaway.
Q. Describe the current ownership structure and provide an organizational overview.
A. Cove Street Capital is 100% employee owned.

The two principals are Jeffrey Bronchick, CFA who oversees all investing activity and Daniele Beasley, who oversees operations, compliance and client service.

We have nine full-time employees that comprise our three departments—Research + Investments, Business Development + Client Service, and Compliance + Operations. Please see the ABOUT US tab for a list of employees and their full biographies.
Q. Is the firm registered with any regulatory agency?
A. Cove Street is a US-based investment management firm and is registered as an investment advisor with the Securities and Exchange Commission.
Q. Provide a description of any litigation or regulatory actions involving the firm or any of its principals.
A. The firm has not been a party to any litigation or any regulatory actions and is not aware of any such pending activity.
Q. Describe the culture of the firm.
A. We are a highly motivated, entrepreneurial, and open ecosystem. Every member of the firm understands DHM and the importance of its ordering—Delight Clients, Have Fun, Make Money. The atmosphere is highly collaborative and ideas flow across rank and job description, enabling "failure free" expression. The best thing a human being can do is help another human being know more—personal growth is encouraged and compensated. Resonating themes include: unwavering ethics and devotion to client first; independent work with full accountability; ownership mentality; a focus on what is the "best way," not "this is how it has been done before;" and submission of rank and seniority to best idea and best practice.
Top

Strategy Overview

Q. What investment strategies does the firm offer?
A. Cove Street offers the following strategies on a separate account, mutual fund, or sub-advised basis:

CSC Classic Value | Small Cap
Small Cap is a concentrated small cap value strategy that applies a fundamental, bottom-up stock selection process on a universe of approximately 3,500 US companies with a market capitalization below $3 billion, as well as a relevant universe of non-US companies.

We consistently run computer screens to identify "fishing pools" of statistically cheap securities and highly desirable business models. We also draw upon a deep cumulative well of investment experience and industry contacts to find and identify ideas. Cove Street "team tackles" fundamental business model drivers and establishes intrinsic value targets with a multivariate approach, incorporating discounted cashflow, historical valuation metrics, and private market and asset-based valuations. We pay careful attention to "management" and quantitatively review historical capital allocation decisions as well as Board composition and compensation structure.

The portfolio holds 30 to 39 stocks, and includes a restriction that a single security position will not exceed 10% of the portfolio. CIO Jeffrey Bronchick is responsible for the final portfolio decision. Sector weightings are a result of the bottom-up approach, with a 30% risk limit in any single industry. We are very mindful of the negative correlation between asset growth and performance, and Cove Street will err on the side of protecting existing clients and close the strategy in the face of aggressive asset flow.

Less is more in regards to portfolio turnover, as experience has proven that the quality of decision-making decreases with frequency. That said, mistakes are inevitable and our concentrated research assists in identifying errors relatively early. Stocks are also sold when their price no longer reflects a margin of safety, or we have identified materially better values in other stocks.

CSC Classic Value | All Cap
All Cap applies a fundamental, bottom-up stock selection within an unrestricted, global universe. We consistently run computer screens to identify "fishing pools" of statistically cheap securities and highly desirable business models. We also draw upon a deep cumulative well of investment experience and industry contacts to find and identify ideas. Cove Street "team tackles" fundamental business model drivers and establishes intrinsic value targets with a multivariate approach, incorporating discounted cashflow, historical valuation metrics and private market and asset-based valuations. We pay careful attention to "management" and quantitatively review historical capital allocation decisions as well as Board composition and compensation structure.

All Cap holds 20 to 25 stocks in a portfolio, with a single security position not to exceed 10%. CIO Jeffrey Bronchick is responsible for the final portfolio decision. Sector weightings are a result of the bottom-up approach, with a 30% risk limit in any single industry.

Less is more in regards to portfolio turnover, as experience has proven that the quality of decision-making decreases with frequency. That said, mistakes are inevitable and our concentrated research assists in identifying errors relatively early. Stocks are also sold when their price no longer reflects a margin of safety, or we have identified materially better values in other stocks.

CSC Classic Value | Strategic
Strategic Value is a classic balanced strategy seeking absolute returns throughout market cycles by investing across the corporate capital structure and holding cash when alternative investment opportunities are not forthcoming. In contrast to what is broadly called a "hedge fund," Strategic Value has a transparent process, does not use leverage or shorting and fees are reasonable. The portfolio uses an All Cap equity universe with a global opportunity set and an opportunistic fixed income strategy utilizing the firm's bottom-up credit research. CIO Jeffrey Bronchick is responsible for the final portfolio decisions.

CSC Classic Value | Small Cap Focus
Small Cap Focus is a concentrated strategy of the 8 to13 best ideas from our Classic Value | Small Cap strategy. The strategy mirrors the strategy employed in our sub-advisory for the Litman Gregory Masters' Select Smaller Companies Fund mandate.
Q. Please provide a breakdown of your firm's current investors as of 6/30/2013.
A.
Asset Breakdown
Small Cap Value 57%
Strategic Value 21%
All Cap Value 16%
Large Cap Value 7%
Client Type
High Net Worth 21%
Institutional 79%
Q. How do you think about capacity in the firm's current strategies?
A. There is not a more valid truism in the investment management business than the assertion that asset growth is the enemy of performance.

We presently believe that we have $1.3 billion in capacity in our small cap strategy, which will allow small cap representation in other strategies. We do not think our other strategies have capacity limitations under $10 billion in assets.
Q. Are any of the firm's strategies tax efficient?
A. While investment considerations should almost always trump a tax decision, the principals of Cove Street have over 20 years of experience in managing taxable accounts. Our separate account structure and focus on a smaller number of substantial relationships enables tactical tax planning per client needs.
Q. Please provide a list of the firm's service providers.
A.
Legal: Morgan, Lewis & Bockius
Miami, Florida
Accounting: EisnerAmper LLP
San Francisco, CA
Performance Verification: ACA Compliance Group Beacon Verification Services
Chattanooga, Tennessee
Portfolio Accounting /
Order Management Software:
Advent Software Inc.
San Francisco, California
Compliance Resource: National Regulatory Services
Lakeland, Connecticut
We have or can establish custody relationships with all quality financial institutions.
Q. Please list the firm's insurance coverage.
A.
Errors & Omissions: $2,000,000
Chartis—WorldSource
Fiduciary | Fidelity: $5,889,920
Chubb Group of Insurance
EPLI: $2,000,000
The Hartford
Top

Investment Research

Q. Briefly describe the Firm's investment philosophy.
A. We are classic value investors in the tradition of Ben 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, and work and time value are not wasted through committees and laborious people management processes.

We run concentrated portfolios, which allow 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 and 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 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." 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, and conversely, a fairly concentrated portfolio within 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 dollars for 60 cents—is not easy in practice. It requires discipline and patience, attributes that have proven not be innately natural in 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.
Q. Please describe the investment team for the Firm's strategies.
A. Our CIO and Founder Jeffrey Bronchick, CFA leads a team of two analysts that drive the research process for the Firm's strategies. He is final decision-maker on all investment decisions. Full biographies are available on the ABOUT US tab.

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, and work and time value are not wasted through committees and laborious people management processes. We run concentrated portfolios, in a limited number of strategies with a long-term time horizon that leads to low turnover, a process that lends itself well to our structure.

As noted 20th century social scientist Herbert Simon noted, "A wealth of information creates a poverty of attention."
Q. How does the research process work?
A. Idea generation, Stage 1, is driven by both quantitative and qualitative processes. As a value-based, bottom-up manager, we consistently screen markets for securities that appear statistically inexpensive and have that pool of ideas drive our efforts and work rather than begin the day with a preconceived notion of what we would like buy. We also screen for "good businesses" as defined by classic characteristics like consistency of growth and profitability, high returns on invested capital and sustainable competitive advantages; and ask ourselves if the valuation is cheap enough to provide a proper margin of safety. Lastly, we screen on corporate and executive behavior such as share repurchase and insider buying and selling. On a qualitative basis, ideas are produced from our collective investment experience, our deep contact network, out of office experiences and obvious headline issues.

Once we have determined that an idea has promise, we begin Stage 2, which consists of the data download of all relevant company financial information into the Cove Street analytical spreadsheet and we digest all public company information. We then ask: Does it appear to either be a great business at a reasonable price or an exceedingly cheap security that provides a deeper margin of safety to compensate for potential business issues?

Stage 3 is the Team Tackle and Deep Dive. The research team performs intensive analysis on valuation and business characteristics, with two analysts focused on the stock as a "purchase" and one analyst focused on the stock as a "short-sale," a version of the so-called Socratic method of reasoning. Key pivot points include:
  • What is a reasonable estimate of intrinsic value? We incorporate a multivariate approach that utilizes a discounted cashflow analysis, private market values, and a historical calculation of enterprise value to normalized earnings, cashflow and revenue.
  • Classic Porter value chain analysis of competitors, suppliers, potential entrants, customers and substitutes.
  • Is there a competitive advantage that can generate sustainably strong returns on invested capital?
  • Management: friend, neutral or foe?
  • PEST Control: political, economic, social, technological issues.
  • What are we thinking that others are not?
  • What will it cost us if things go very wrong?
Stage 4 is Portfolio Consideration. Is there sufficient risk adjusted upside - on an absolute basis and vs. other stocks we own? How does it fit with the portfolio's industry concentration? Tactical timing issues: Full (5%) or half (2.5%) position? All decisions are recorded on the CSC Decision Process Spreadsheet with all team member opinions noted.

The final decision is made by the Chief Investment Officer.

Less is more in regards to portfolio turnover, as experience has proven that the quality of decision-making decreases with frequency. That said, mistakes are inevitable and our concentrated research assists in identifying errors relatively early.

Our sell discipline is also based upon a blend of qualitative and quantitative measures:

Valuation:
  • A good business is excessively valued or a reasonable business is fairly valued.
  • A better idea is found that materially improves the risk/reward characteristics.
People:
  • Unexpectedly poor decisions are made allocating shareholder capital.
  • Loss of confidence that management and the board are best representing shareholders and the cost and effort to influence this process are deemed prohibitive.
Business:
  • We are incorrect in our expectations about long term economic margins and earnings power.
  • Actual or likely prospects of balance sheet deterioration.
  • Cyclical industry problems reveal themselves as secular.
Q. How is the investment team compensated?
A. There is a competitive salary structure plus a bonus that is performance-based and incorporates qualitative factors such as internal teamwork, client-facing activities and the improvement of CSC's investment and operational infrastructure. There is a longer term path to equity ownership that is documented in the firm’s Operating Agreement.
Top

Portfolio Management

Q. Please describe the portfolio construction process?
A. Cove Street tends to have relatively concentrated portfolios with relatively low turnover. There are typically 30 to 39 stocks in our Small Cap strategy and 20 to 25 in our All Cap strategy. Our initial position will typically start as a half position at 2.5% of the portfolio or a full position at 5%, depending on tactical considerations at the time of purchase.

We do not in any way seek to replicate market indices as far as sector weightings. We will limit our exposure to a particular industry to 25% of the portfolio on the behavioral finance suggestion of the potential for hubris in investment management.

While we are generally investing with a three to five year outlook, stock and market volatility can produce swings that enable value-adding shifts in position weighting within the context of our longer-term outlook.
Q. Describe the investment environments in which the Firm's strategies are most likely to outperform or underperform style peers?
A. As a general statement, our goal is to generate competitive returns in strong up markets and outperform in down markets. This is a state of affairs that has held true over twenty years of market cycles, with the exception of 2008/2009, where the exact opposite held true. We would suggest that truly was a "Black Swan" period and recent years have seen portfolios revert back to more traditional behavior.
Q. What are the most appropriate benchmarks for your investment strategies?
A. We have often said, benchmarks are like potato chips—it is difficult to have one. Our reasoning is that indices have statistical biases just as our portfolios have certain biases, and particularly over short-run, these inherent biases can make the portfolio manager look better—or worse—than the long-run might eventually suggest.

For All Cap portfolios, the Russell 3000® is a reasonably appropriate benchmark and in Small Cap, the Russell 2000® is the counterpart. Each index has a value-oriented counterpart—the Russell 3000® Value and the Russell 2000® Value, indices that can provide "color" to the short-term performance story. For the Strategic Value portfolios, a blended index of the Russell 3000® with the Barclays Capital Government/Credit Index (BCGCI) and additionally the HFRI Equity Hedge Fund serve as appropriate benchmarks. Our job is fiendishly simple—protect capital in difficult markets and outperform benchmark indices over the long-run. To do so, one must be willing to be "different" than the indices and have an investment discipline and client support to endure inevitable periods of short-term discomfort when the "trend du jour" reflects itself in short-term underperformance versus an index.

We recognize that diversifying investment managers by "style" is pervasive and it can reduce the probability of significant under-performance in the short-run, but we believe that in today's investment world, the "styles" are defined too mechanically. Assigning each manager a specific" style box" in a matrix overlooks the reality that managers are of different sizes and shapes and they overlap in non-quantifiable ways. This is not to say that managers should not be held accountable for performance, but to manage to a box or an index is to nearly guarantee mediocre performance.

Since we run concentrated portfolios that focus on our best ideas without regard to index composition, we recognize that some consultants and advisors can have a difficult time "fitting" in our strategies. We apologize for the headaches we cause on this score, but we believe we need to be faithful to our investment philosophy.
Q. Do you hold cash?
A. Yes, when we find little to buy that provides a margin of safety for other people's money. Cash is a residual of our investment process rather than a "feeling" that all is not right in the world. The world was certainly not a comfortable place in March 2009, but the outcome of any reasonable investment process called for at least gingerly stepping forward and spending cash. The converse was true in June 2007. We will immediately communicate with the client and intermediaries if we are having difficulty finding enough value to meet investment guidelines on cash holdings.
Q. What is the turnover of your portfolios?
A. Our turnover is as low as we can make it, but much depends on the volatility of markets. Our turnover has averaged roughly 35% over a long period of time, but there have been years where it has been as low as 10% and as high as 60%. It can lean higher in Small Cap portfolios due to inherently higher volatility and takeovers.
Q. How do you define risk and how is portfolio risk managed?
A. In its purest form, risk is the likelihood of permanently losing money. As the world remains inherently uncertain in terms of outcome, we reject the idea that risk can adequately be defined by volatility. If an investment time horizon is appropriately aligned with the style of management, short-term "quotational risk" should be a factor that is de minimis as one views a longer-term investment program.

Our intensive investment process is our best source of risk control—we know what we own, we believe the valuation suggests a proper margin of safety if we are wrong, and we have concentrated portfolios, a fact that means we are fully engaged in watching the basket closely.

Both the Chief Investment Officer and the Chief Compliance Officer lead efforts to ensure that client portfolios are managed within the respective guidelines.

We also identify with this excerpt from an investment memo from Oaktree Capital's Howard Marks (reprint verbatim):

Investment risk comes in many forms. Many risks matter to some investors but not to others, and they may make a given investment seem safe for some investors but risky for others.
  • Falling short of one's goals - Investors have difficult needs, and for each investor the failure to meet those needs poses as risk. A retired executive may need 4 percent per year to pay the bills, whereas 6 percent would represent a windfall. But for a pension fund that has to average 8 percent per year, a prolonged period returning 6 percent would entail serous risk. Obviously this risk is personal and subjective, as opposed to absolute and objective. A given investment may be risky in this regard for some people but riskless for others. Thus this cannot be the risk for which "the market" demands compensation in the form of higher prospective returns.
  • Underperformance - Let's say an investment manager knows there won't be more money forthcoming no matter how well a client's account performs, but it's clear the account will be lost if it fails to keep up with some index. That's "benchmark risk," and the manager can eliminate it by emulating the index. But every investor who's unwilling to throw in the towel on outperformance, and who chooses to deviate from the index in its pursuit, will have periods of significant underperformance. In fact, since many of the best investors stick most strongly to their approach - and since no approach will work all the time - the best investors can have some of the greatest periods of underperformance. Specifically, in crazy times, disciplined investors willingly accept the risk of not taking enough risk to keep up. (See Warren Buffett and Julian Robertson in 1999. That year, underperformance was a badge of courage because it denoted a refusal to participate in the tech bubble.)
  • Career risk - This is the extreme form of underperformance risk: the risk that arises when the people who manage money and the people whose money it is are different people. In those cases, the managers (or "agents") may not care as much about gains, in which they won't share, but may be deathly afraid of losses that could cost them their jobs. The implication is clear: risk that could jeopardize return to an agent's firing point is rarely worth taking.
  • Unconventionality - Along similar lines, there's the risk of being different. Stewards of other people's money can be more comfortable turning in average performance, regardless of where it stands in absolute terms, than with the possibility that unconventional actions will prove unsuccessful and get them fired. Concern over this risk keeps many people from superior results, but it also creates opportunities in unorthodox investments for those who dare to be different.
  • Illiquidity - If an investor needs money with which to pay for surgery in three months or buy a home in a year, he or she may be unable to make an investment that can't be counted on for liquidity that meets the schedule. Thus, for an investor, risk isn't just losing money or volatility, or any of the above. It's being unable when needed to turn an investment into cash at a reasonable price. This, too, is a personal risk.
Q. What aspects of your investment approach differentiate you from other managers?
A. We believe that deep fundamental research, concentrating on our best ideas, and thinking and actually acting like a long-term investor with lower turnover differentiate us from many other managers.
Q. Are any of the firm's strategies tax efficient?
A. While investment considerations should almost always trump a tax decision, the lead principal of Cove Street has over 24 years of experience in managing taxable accounts. Our separate account structure and focus on a smaller number of substantial relationships enables tactical tax planning per client needs.
Top

Trading + Execution

Q. Please describe the Firm's trading operations and processes.
A. CSC has a head trader who works closely with the firm's research team to achieve best execution within the context of investment goals. Each order is evaluated to determine the optimal execution strategy. We have numerous relationships with large and small broker dealers, and we make extensive use of technology to utilize electronic trading platforms, dark liquidity pools, and algorithmic trading tactics. In making the broker selection, factors involved include liquidity offered in a specific name, size of the order, urgency of the investment decision, estimated market impact and commission costs. We also have some client relationships that specifically direct our order flow.

At the end of each day, the trading desk produces a trading blotter that is electronically disseminated to the research team and firm's compliance officer.
Q. Please provide an overview of the trade allocation process.
A. Cove Street Capital, LLC has adopted a clear written policy for the fair and equitable allocation of transactions (e.g., pro-rata allocation, rotational allocation or other means) that is disclosed in the firm's Disclosure Document. CSC's policy, which is available upon request, prohibits any allocation of trades in a manner that the firm's proprietary accounts, affiliated accounts, or any particular client or group of clients receive(s) more favorable treatment than other client accounts.

Allocation of Partial Fills: From time to time, in volatile markets or with more thinly-traded small cap names, there are often orders that are not fully completed on a given day. CSC allocates partial fills on a pro-rata basis subject to appropriate and reasonable fill percentages.
Q. Describe the firm's brokerage direction policies.
A. Cove Street Capital, LLC may accept client instructions for directing the client's brokerage transactions to a particular broker-dealer. Any client instructions to CSC must be in writing for any directed brokerage arrangements. In such cases, clients must be aware that CSC may not negotiate commissions, obtain volume discounts or aggregate directed transactions, and that commission charges will vary among clients.
Q. Do you evaluate trading costs on an ongoing basis?
A. CSC engages in a monthly review of trading costs. At this meeting, the CIO, COO, and the trading desk discuss commission levels, and review a firm-wide Trade Cost Analysis (TCA) to evaluate best execution practices and current brokerage relationships. The TCA report and analysis is provided by Instinet.
Q. Please describe the firm's order management system.
A. Moxy is our OMS platform used to improve performance and workflow at Cove Street Capital. The system allows CSC to efficiently handle increased trading volume and work with disparate brokers and custodians, and it works seamlessly with our Advent portfolio accounting system.
Q. Please outline the Firm's trade error policy.
A. CSC attempts to minimize trade errors by using various systems that automate daily trading and the reconciliation process that promptly report trade details. When we do discover an error, it is immediately reported to the President of the firm for review and resolution. If the error is not in the client's financial favor, we make the client whole. as soon as practically possible. We keep an error log book in order to improve current policies and procedures to prevent the error from recurring.
Q. Does the firm utilize soft dollars?
A. CSC does not pay for research services through contractual soft-dollar arrangements. There are no predetermined commission commitments to pay any broker for research or any other services. We do not have an affiliation with a broker dealer.
Top

Operations

Q. Please provide an overview of the Firm's operational capabilities.
A. President Daniele Beasley has had over twenty years of experience designing and implementing leading edge technology platforms for registered investment advisors and broker dealers. CSC uses Advent Software's order management solution, Moxy and its portfolio management and accounting software, Advent Portfolio Exchange (APX).

CSC will continue to lever its relationship with its technology partner, NIC. NIC is a Los Angeles-based Information Technology consulting firm that was founded in 2002. NIC specializes in addressing the needs of investment advisors and provides Cove Street Capital with cloud computing services as well as technical support. Disaster Recovery Services, Regulatory Compliance, and Data Security are also facilitated for CSC by utilizing enterprise level solutions managed by NIC. With the assistance of NIC, Cove Street Capital leverages state-of-the-art technology to create an efficient and reliable infrastructure for its information systems and data.
Q. Describe the process by which portfolio transactions are reconciled.
A. Via Advent Software solutions, CSC will obtain custodial data through Advent Custodial Data. This allows CSC the ability to consolidate account level information from more than 800 custodians and funds for reconciliation and posting into APX. Data is trade-date based and is available before the market opens in T+1.
Q. What is the firm's valuation standard for its portfolio positions?
A. CSC has adopted a pricing policy which requires all client portfolios to reflect current, fair, and accurate market valuations. Through integration with APX, CSC obtains prices and reference data for all held securities through Interactive Data Corporation (IDC).

On the rare occasion when pricing information for a thinly traded security is not ascertainable, CSC's policy is to price at the lower end of the bid-ask spread or the last trade.
Q. How does the firm handle proxy votes and regulatory filings?
A. Cove Street Capital acts as discretionary investment adviser, including clients governed by the Employee Retirement Income Security Act of 1974 ("ERISA"). CSC manages both equity and fixed income securities for its clients and will hold voting securities (or securities for which shareholder action is solicited) in a client account. Thus, unless a client (including a "named fiduciary" under ERISA) specifically reserves the right to vote its own proxies or to take shareholder action in other corporate actions, CSC will vote all proxies or act on all other actions received in sufficient time prior to their deadlines as part of its full discretionary authority over the assets.

When voting proxies or acting on corporate actions for clients, CSC's concern is that all decisions be made solely in the best interest of the shareholder (for ERISA accounts, plan beneficiaries and participants, in accordance with the letter and spirit of ERISA). CSC will act in a manner deemed prudent and diligent and which is intended to enhance the economic value of the assets of the accounts.
Top

Legal + Compliance

Q. Please provide an overview of the Firm's legal and compliance functions.
A. CSC has adopted policies and procedures that it believes are reasonably designed to prevent violations of the Investment Advisers Act of 1940, in accordance with Rule 206(4)-(7) under the Advisers Act.

The members of the CSC Compliance Department, along with outside counsel Morgan Lewis & Bockius, are primarily responsible for the development and implementation of appropriate policies and procedures. Monitoring systems are tailored to particular policies and procedures, the manner and frequency of testing varying as appropriate.

CSC's compliance procedures include the reporting of violations or errors to designated personnel. After any preliminary due diligence and investigation, matters are corrected or resolved in an appropriate manner. Resolution will vary depending on, among other things, the nature and severity of the violation.

CSC recognizes that compliance policies and procedures are living documents and are constantly evolving and improving. As in the past, the CSC Compliance Department intends to continually monitor regulatory developments and review these materials to reflect any new rules and any amendments to existing rules, as well as other regulatory developments.

Daniele Beasley is CSC's Chief Compliance Officer (CCO) and administers its compliance policies and procedures. The CCO is responsible for overseeing the establishment and implementation of policies and procedures governing the activities of CSC to assure compliance with federal securities laws; maintaining compliance-related books and records; training colleagues to assure compliance with applicable compliance policies; assisting in the provision of information to regulators as requested in the course of an examination; and periodically reviewing compliance programs for effectiveness of implementation and conformity with relevant laws and regulations.
Q. Does CSC maintain a compliance manual?
A. Yes. The following is a list of the policies and procedures which comprise CSC's Compliance Program. The Compliance Program addresses the conflicts and other risk factors that create risk exposure for CSC and its clients, including those identified by the SEC in its release of Rule 206(4)-7.
  • Advertising
  • Advisory Agreement
  • Agency Cross Transactions
  • Annual Compliance Reviews
  • Anti-Money Laundering
  • Best Execution
  • Books and Records
  • Code of Ethics
  • Complaints
  • Corporate Records
  • Custody
  • Directed Brokerage
  • Disaster Recovery
  • Disclosure Document (ADV)
  • E-Mail and other Electronic Communications
  • ERISA
  • Insider Trading
  • Investment Processes
  • Performance
  • Personal Securities Transactions & Records
  • Principal Trading
  • Privacy
  • Proxy Voting
  • Registration / Regulatory Reporting
  • Soft Dollars
  • Solicitor Arrangements
  • Supervision & Internal Controls
  • Trading
  • Valuation of Securities
  • Wrap Fee Adviser
Q. Summarize CSC's personal trading policy.
A. All employees are subject to the policies and procedures of CSC, including the Code of Ethics (the "Code"). All personnel are required to read and be familiar with the Code, the Policy, and the Compliance Program.

The policy of CSC is to avoid any conflict of interest, or the appearance of any conflict of interest, between the interests of CSC, or its officers, partners and employees, and the interests of CSC's advisory clients ("Clients"). The Investment Company Act and rules require that CSC establish standards and procedures for the detection and prevention of certain conflicts of interest, including activities by which persons having knowledge of the investments and investment intentions of clients might take advantage of that knowledge for their own benefit.

This Code of Ethics has been adopted by CSC to meet those concerns and legal requirements. Any questions about the Code or about the applicability of the Code to a personal securities transaction should be directed to CSC's designated Compliance Officer, Daniele Beasley. If the Compliance Officer is not available, questions should be directed to a principal of CSC or its Counsel.

Personal Securities Transactions: The Code regulates personal securities transactions as a part of the effort by CSC to detect and prevent conduct that might violate the general prohibitions outlined above. A personal securities transaction is a transaction in a security in which the person subject to this Code has a beneficial interest. Security is interpreted very broadly for this purpose, and includes any right to acquire any security (an option or warrant, for example), and shares of any open-end investment companies for which CSC serves as investment adviser or sub-adviser, including the CSC Small Cap Value Fund (the "Fund").

Beneficial interest in a security exists when an individual has, directly or indirectly, the opportunity to profit or share in any profit derived from action in the security; or when there is an indirect interest, including beneficial ownership by the individual's spouse or minor children or other dependents living in the individual's household; or where securities are held by a partnership of which the individual is a general partner. Technically, the rules under Section 16 of the Securities Exchange Act of 1934 will be applied to determine if a beneficial interest in a security exists (even if the security would not be within the scope of section 16).

In any situation where the potential for conflict exists, transactions for clients must take precedence over any personal transaction. The people subject to this Code owe a duty to clients to conduct their personal securities transactions in a manner which does not interfere with clients' portfolio transactions or otherwise take inappropriate advantage of their relationship with clients. Personal securities transactions must comply with the Code of Ethics and should avoid any actual or potential conflict of interest between employees' interests and clients' interests.

Pre-Clearance: All personal securities transactions must be conducted through brokerage accounts that have been identified to the Compliance Officer (or in her absence a Principal of the firm). Each such brokerage account must be set up to deliver duplicate copies of all confirmations and statements to the Compliance Officer. All personal securities transactions must be cleared in advance by the Compliance Officer (or in her absence a Principal of the firm).

Blackout Periods: No personal securities transaction of an investment person will be cleared if (1) a conflicting order is pending for any clients or (2) CSC is actively considering a purchase or sale of the same security. A conflicting order is any order for the same security, or for an option on or a warrant for that security, which has not been fully executed. A purchase or sale of a security is being "actively considered" (a) when a recommendation to purchase or sell has been made for any Client and is pending, or, (b) with respect to the person making the recommendation, when that person is seriously considering making the recommendation.

Absent extraordinary circumstances, a personal securities transaction for an investment person will not be approved until the business day after completion of any transaction for any Client.
Q. What AML polices does CSC have in place?
A. It is the policy of CSC to seek to prevent the misuse of the funds it manages, as well as prevent the use of its personnel and facilities for the purpose of money laundering and terrorist financing. CSC has adopted and enforces policies, procedures and controls with the objective of detecting and deterring the occurrence of money laundering, terrorist financing and other illegal activity. Anti-money laundering "AML" compliance is the responsibility of every employee. Therefore, any employee detecting any suspicious activity is required to immediately report such activity to the CCO, Daniele Beasley. The employee making such a report should not discuss the suspicious activity or the report with the client in question.

Before opening an accounting for an individual, CSC will require satisfactory documentary evidence of a client's name, address, date of birth, social security number or, if applicable, tax identification number. Before opening an account for a corporation or other legal entity, CSC will require satisfactory evidence of the entity's name, address and that the acting principal has been duly authorized to open the account. The CCO will retain records of all documentation that has been relied upon for client identification for a period of five years.

CSC will not open accounting or accept funds or securities from, or on behalf of, any person or entity whose name appears on the List of Specially Designated Nationals and Block Persons maintain by the U.S. Office of Foreign Assets Control, from any Foreign Shell Bank or from any other prohibited persons or entities as may be mandated by applicable law or regulation as designated by the OFAC Country Sanctions Program.

CSC's CCO will conduct annual employee training programs for all personnel regarding the AML program. In addition, the CCO will conduct an annual review of existing clients versus the updated SDN and Country Sanctions Program and report any positive findings to the Board.
Q. Is your firm in compliance with the Global Investment Performance Standards (GIPS®)?
A. Yes. CSC claims compliance with the GIPS® and upon request can provide presentations that are in compliance with the GIPS® standards. We have been verified through June 30, 2013.
Q. Are CSC's performance records audited?
A. Yes. ACA Beacon Verification Services has completed its performance examination for our composites through June 30, 2013 and will continue to do so on a semi-annual basis.
Q. Please provide an overview of your disaster recovery plan?
A. Cove Street Capital has developed a Business Continuity Plan "BCP" on how team members will respond to events that significantly disrupt our business. Since the timing and impact of disasters and disruptions is unpredictable, we will have to be flexible in responding to actual events as they occur. With that in mind, we are providing you with this information on our BCP.

Communication: In the event of a major disruption, our main telephone line will be forwarded to an emergency number by Daniele Beasley. If you can't contact us through one of these means, you should contact your custodian to enter any orders and process other trade-related, cash and security transfer transactions. If at all possible, updated contact information in the event of an emergency will be provided via our website, www.covestreetcapital.com.

Our Business Continuity Plan: We plan to quickly recover and resume business operations after a significant business disruption and respond by safeguarding our employees and property, making a financial and operational assessment, protecting the firm's books and records, and allowing our customers to transact business. In short, our business continuity plan is designed to permit our firm to resume operations as quickly as possible, given the scope and severity of the significant business disruption.

Our BCP addresses: data back-up and recovery; all mission critical systems; financial and operations assessments; alternative communications with customers, employees, and regulators; alternate physical location of employees; critical bank and counter-party impact; regulatory reporting; and assuring our clients prompt access to their funds and securities if we are unable to continue business.

CSC and its vendors back-up our important records in a geographically separate area. While every emergency situation poses unique problems based on external factors, such as time of day and the severity of the disruption, we have been advised by our counter-parties that business should resume within 4-24 hours. Your orders and requests for funds and securities could be delayed during this period.

Varying Disruptions: Significant business disruptions can vary in their scope, such as only our firm, a single building housing our firm, the business district where our firm is located, the city where we are located, or the whole region. Within each of these areas, the severity of the disruption can also vary from minimal to severe. In a disruption to only our firm or a building housing our firm, we will transfer our operations to a site outside of the affected area, and recover and resume business within 3 business days. In either situation, we plan to continue in business and notify you through our website www.covestreetcapital.com or our customer emergency numbers on how to contact us.
Top

Compliance Forms

ADV Part I

ADV Part 2A

ADV Part 2B

Privacy Policy

Top

Other Questions We Have Fielded

Q. How important is the evaluation of management and company visits?
A. The evaluation of management is crucial, as poor strategic and capital allocation decisions can badly hamper an otherwise reasonable business selling at a reasonable valuation. We check in with management to understand the basic game plan, but we have come to appreciate an old saying, "the more we talk to management, the dumber we get." Thus, we believe a careful analysis of management's background and compensation structure, the composition of the Board of Directors, and following long-term trends in return on invested capital are much more valuable to understand "management" than company presentations.
Q. Should I be concerned about being a large percentage of your asset base or a high percentage of a strategy's assets?
A. To avoid an obvious and self-serving no, let me again steal from Howard Marks at Oaktree Capital who runs $90 billion in assets and for whom this question probably doesn't come up much anymore:

I've heard committees say, "we don't want to represent more than x% of a manager's assets under management or of the fund's total capital." But why not? Is the goal better performance or is it safety in numbers? If you're considering investing $10 million with a manager, why does it matter how much money she manages? Why is investing $10mm safe if she manages $1 billion but risky if she manages $50mm? If a manager is unusually skillful, aren't you better off as her client if she manages less money than more? And if a manager was really good, wouldn't you prefer that she managed only your money?

My most specific and most heartfelt advice is this: The surest way to achieve superior performance is by investing significant amounts with individuals and firms that can be depended upon for investment skill, risk control, and fair treatment of clients.
Q. Do you pursue activist strategies?
A. From time to time in the past, we have moved from our perch as passive investors and engaged management in order to improve current corporate governance practices, redesign executive pay packages, or seriously discuss capital allocation decisions. We would call this more of a "suggestivist" approach rather than activist. Ideally, this is accomplished through rational meetings and conversations with company management and/or the Board of Directors. Our experience in these areas has suggested that further action can periodically be required, as we have noticed that human behavior begins to change when people realize they are being observed. This has involved filing 13-D's with the SEC indicating our interest in pursuing such discussions with company management and other material shareholders. Our goals are very simply to protect our rights as shareholders as well as to encourage actions that benefit all shareholders and we weigh the gains to be had versus the time and dollars that need to be expended to achieve such an end.
Q. How do you quantify Risk/Reward?
A. Before one makes an investment, you must have some approximation of a target price. Proceeding without one is equivalent to trying to throw a ball at a target blindfolded. Additionally, one attempts to also quantify the risk of being somewhat to terribly wrong under a variety of scenarios. Both processes are "multi-variate" which incorporates a number of possible outcomes, both positive and negative. Portfolio weights also come into play here as higher reward/higher risk specific ideas can be risk-weighted in the portfolio by a smaller position. It is crucial to understand that "quantification" of target prices can be highly imprecise, subject to great change with the passage of time and/or the panoply of unforeseen circumstances.
Q. Does your organization have a policy regarding the integration of environmental, social and corporate governance (ESG) issues in investment processes?
A. We have managed ESG clients for 20 years and are very comfortable managing client ESG issues per client request.
Q. Shouldn't Cove Street specialize in either "Graham" or "Buffett" stocks and develop a deep understanding of the stocks that fit those criteria as opposed to investing in both types?
A. No. There are no points for purity given out in performance rankings. "Value" innately involves the analysis of the nature of the underlying business, an estimate of what it is worth and a judgment call as to the competence and incentive of management to deliver value growth or to take steps to close the gap between the security price and the intrinsic value. Ignoring any part of this triad can lead to permanent capital loss. The process for identifying "value" is exactly the same in either what can be termed a "Buffett" or "Graham" approach—what is different is how an investor weights the factors. There are simply times when the price of a security more than compensates you for business risk and there are times where the price is so egregious that it puts you at risk of permanent capital loss no matter how good the business. We also think people misunderstand much of what Buffett professes, as much of it is due more to the size of his portfolio than some intellectual fault with buying statistically cheap stocks.
Q. With respect to the sell discipline, what prompts a review? How do you apply your sell discipline to the Buffett values?
A. 1. Valuation.

2. A corporate event that requires possible action.

3. Under continuous analysis theory, the conclusion has been reached that a mistake has been made in our analysis that risks permanently impairing our capital.

4. A better idea has been found and we can upgrade the price/value of the portfolio.

5. We tend to let our sense of a "Buffett" value compound over time and likewise, we are more likely to sell a "Graham" stock when it reaches our initial estimate of fair value. Think a tree vs. a wooden table.
Q. How does the rise of ETFs impact value investing and small cap value investing in particular?
A. Anything that creates more money not paying micro attention to individual securities is a long term positive in our opinion.
Q. At this point you have a significant energy exposure, how do you create alpha in a commodity driven industry?
A. A major and underappreciated change in capital allocation strategy is a very plausible way to make superior returns in commodity businesses from time to time.
Q. Do you have a specific required rate of return hurdle for each stock that is purchased in the portfolio?
A. We target a 50% return threshold over 3 years with a downside of boredom.
Q. How do you get comfortable with the downside scenarios? How do you know that the downside is boredom?
A. While the future remains uncertain, we use deep fundamental work, multi-variate analysis versus one measure of value, absolute and relative work, and experience. We attempt to be savvy about "risk-weighting" positions with higher risk/reward scenarios so that the penalty for a mistake is minimized. We assume our downside is 20% below our pessimistic scenario.
Q. Why have the 2.5% and 5.0% positions? Isn't there incremental value in more actively managing the weights within the portfolio?
A. Less is more. The value-add in the security selection is not wasting time in making frequent position changes. We will "shade" a position but hold that activity up to a materiality bar.
Q. I plugged your portfolio into our software and then marked it up to 1.3 billion in assets and determined that it would take you 23 years to sell "----"...and a number of others would have liquidity problems?
A. That is a theoretical exercise that is not really applicable in day-to-day portfolio management. The fact of life as a small cap manager is that you are buying x stocks at 100mm in assets that you cannot buy at 300mm in assets...and there are stocks you are buying at 300mm in assets that you can't buy at 600mm in assets etc. We have no issues with 4 to 5 stocks out of 34 being "private equity" like - one of the core fundamentals of the longstanding academic support for why small cap value outperforms is fear of liquidity—we take advantage of that but recognize there is a limit to how far you can take it. We also invested in an experienced trader which is a key factor in finding liquidity on both sides. Liquidity is an ephemeral issue—you cannot take 30 day averages and project it into the future. There is often huge liquidity at inflection points which dries up in the "middle." Ideally, we are there at both inflection points—distressed value and then excitement and greed.
Q. How do you ensure that the statistically cheap stocks aren't value traps?
A. Value traps are always value traps...in hindsight. In other words, if it works, it's not a value trap. There are certain characteristics that lead to value traps. For example, a company with an extremely conservative financial policy and entrenched management that has no desire to increase the dynamism of the company or to realize the value in the security can lead to a value trap—you can be sitting with something for a very long time with relatively little growth in intrinsic value or a corporate event which captures much of the disparity between the market price and asset value.

The question in avoiding a value trap is twofold. First, are the dominant shareholders or management incentivized to have some kind of a transaction that's going to increase the market value of the company in the near future? And second, is the intrinsic value of the company increasing at a relatively attractive rate of return? If you've got the latter, then presumably the valuation is going to rise at least at that rate of return, even preserving a big sum-of -the-parts discount under an unfavorable value trap situation. What you'd love to have is both, but what you want to avoid is where you have neither.
Q. Does our $1.3 billion of Small Cap Capacity account for growth in All Cap?
A. This relationship is a sliding scale. Our assumption for $1.3 billion in small cap is that All Cap shows modest growth. If All Cap grows materially before Small Cap, then we will revise the capacity of Small Cap down.
Q. Has there been an evolution in the philosophy?
A. There is less evolution in the philosophy than evolution in the process—we are always seeking to get better and smarter about understanding businesses, valuation, and people—and how to evaluate them.
Q. Give examples of grass roots research that you have performed, why you decided to do this work and the benefits derived
A. There is no such thing as "grass roots" research. If what you mean is "non-Wall Street" research, then the answer is nearly everything we do constitutes GRR. We build our own models, we pay industry consultants where we think we need additional background, we subscribe to many industry newsletters or blogs—free and paid—to find differing views of an industry, we attend industry trade shows, we utilize Linked-In to find industry sources to talk to, we visit companies and management to further our knowledge and build relationships.
Q. Is the firm a Qualified Professional Asset Manager (QPAM)?
A. Yes.
Q. What differentiates your investment approach from your peers and what gives you an edge versus the firms you compete with?
A. We believe that performing deep fundamental research, concentrating on our best ideas, and thinking and actually acting like long-term investors who are focused on lower turnover differentiate us from many other managers. Consistent application of a classic value strategy and our investment process allow us to not get "caught" in the trends and fads of our industry.

Specifically, using an unwavering contrarian philosophy, we actively seek out companies that are under-followed, under-appreciated and under-loved with the goal of identifying rare but potentially lucrative market inefficiencies.
Q. Do you believe that an investment approach that worked in the past may not work in the future and, therefore, that you need to change or modify your investment approach over time?
A. We think common sense and at least a few hundred years of history support the idea that carefully researching a select group of investment ideas that reasonably appear to be selling at a discount to intrinsic value is not an approach that is in danger of dying out. Our approach may fall into or out of favor from time to time, but we believe that sticking to our core philosophy and process give us the best chance of success over time.
Q. Do you establish price targets for each security in the portfolio? If so, how are they determined? How do you think about downside risk when you are analyzing a stock? Do you like to see a minimum upside/downside relationship?
A. We establish price target ranges for each security that enters our Stage 3: Team Tackle + Deep Dive. We take a multivariate approach to identify the intrinsic value of securities and the underlying companies. The range of tools that we apply includes discounted cash flow, historical comparable trading multiples, private market value, and asset-based methods. No single valuation methodology is applicable in each situation across our investment universe, so we are nimble in terms of using the correct set of tools given the specific company being considered.

We feel giving a voice to the "short" (Devil's Advocate) and developing the Alternative Competing Hypothesis creates a dynamic where there is healthy debate and a more conservative view both in terms of the upside and downside assessments and the corresponding risk/reward of the opportunity. In addition, the team identifies four critical variables that we believe will be outcome determinative. To the extent these variables are quantitative in nature we test the model to assess value in downside scenarios. We very specifically use different valuation models as to not be led down an erroneous path by one variable. We use sensitivity analysis extensively. Price targets are continuously updated as we adapt to new information.

We don't have a specific target for the upside/downside relationship, but we do look for companies with asymmetrical outcomes where the downside is boredom.
Q. Is there an optimal environment for your investment approach? What kinds of markets would you perform best in? Worst in?
A. The goal of a value manager should always be "competitive returns in up-markets and outperformance in down-markets." With the exception of 2008/2009, a period which completely flipped that mantra on its head, that is what investors should expect over the long run. We anticipate that we would do well on an absolute basis in most environments that are dissimilar to 2008 as we have a relatively concentrated portfolio that enables security specific value recognition to deliver performance away from market returns.