This is the first part of a non-vampire trilogy which will explore some of our inner thinking on the juxtaposition of "business vs. value vs. people" in the investment decision making process-a process that has led us to recent investments in Yahoo, Hewlett-Packard and News Corp in our non-small cap strategies. While we have plenty of examples that are applicable in small cap, let's face it-these three are juicy targets that have engendered enough press to ensure the reader will raise some level of visceral disgust and thus serve to make our point. In this first installment, we will focus on Yahoo for no other reason than to honor the company's place within the pantheon of failed corporate governance. 

In a perfect world, an investor would wake up every morning with a portfolio of terrific businesses selling at outstandingly cheap valuations and live a life of contented luxury as a dedicated and shareholder-oriented management team and Board of Directors dutifully represented his interests. The "dream" can be had from time to time if one is patient and has the discipline to wait for the opportunities that seem to develop every 72 hours in today's world. But often investors grapple with a Rolling Stone-esque challenge-we cannot always get what we want. Specifically, the three most common types of situations we encounter are as follows: 1. A great business selling at a high valuation (not for us); 2. A mediocre business selling at an absurdly low valuation (perennial temptation); and 3. A perfectly good business selling at a low valuation because it is being run (or is perceived to be run) by the corporate equivalent of Beavis and Butthead.

The latter is our topic for the day and let's start with Yahoo, a position that has clearly not helped us break the bank. The stock purchase was made in early 2009 at $12 per share, based on some fairly classic value parameters. At the time, when we backed out a reasonable estimate of the after-tax value of the company's Asian assets, there was a negative value implied for the core Yahoo business. One can argue over nearly anything in the investment world, but being paid to accept a business that is essentially debt-free and generates $600mm of free cashflow per year presented a compelling risk-reward tradeoff and led to a price objective of $20 within three years.

The difficult competitive position of Yahoo vs. Google and Facebook for advertising and search revenue was a clearly identified risk and remains a considerable challenge, but the roughly $600mm a year still manages to emerge from the tech equivalent of my father's Oldsmobile. This brings up an interesting and annoying issue we face when we invest in anything related to technology and media. It seems the advent of unbridled social media and free internet access has enabled ANYONE to say nearly ANYTHING on ANY subject on a completely unedited, 24/7 basis. Nowhere is this more prevalent than in the media and technology industries, many of whose inhabitants appear to have little else to do but blog about each player's actual or rumored activities. All of this chatter enables us to second guess any investing decision in real-time, which is why it is so crucial to blend in a few hard facts-such as getting $600mm a year in free cashflow for free.

What was also identified as a "challenge" when shares of Yahoo were purchased and remains a challenge to this day is determining whether or not the management team and the Board are friends or foes of the common shareholder. What we do know is that they turned down a $31 per share buyout offer from Microsoft for reasons that suggest an agenda that does not put the shareholder first. What that agenda was at the time remains unclear to any and all rational beings. Our opinion when we bought the stock was that having made one bonehead strategic move, it would seem unlikely that a shareholder would endure a repeat performance. But according to recent press reports, rational creatures remain underrepresented on the Yahoo Board.

Just prior to our purchase, the fourth version of the "new CEO story" had begun and that was clearly a mixed bag. We confess to sometimes being a sucker for the cheap stock with a new management story. In theory, we are buying small pieces of a real businesses run by real people and often a change in management is the missing link that leads a company to be successful and the stock purchase an investment success. "People" are a qualitative factor that cannot be modeled by a 28-year-old with a spreadsheet and thus organizational change is often underappreciated and undervalued. Oddly, while predicting short-term earnings and stock movements has been statistically proven to be a mugs game for decades, it nonetheless continues to occupy an unhealthy amount of the time of investors, professional and otherwise. Meanwhile, long-term track records of success are seemingly ignored for large swathes of time as stock prices languish. While John Malone's Liberty units are presently a great example, Berkshire Hathaway remains the classic case study as Buffett put up a stupendous public track record and was mostly ignored for decades by "Wall Street" because Berkshire could not be "modeled" and was not courting investment bankers and analyst coverage. We own a variety of "un-model-able" entities where there is definitive current value but the upside clearly stems from the optionality for compounding represented by a historical track record of success and, as such, Wall Street Wallflowers remain an area of further interest.

Back to Yahoo. While Carol Bartz did bring some sense of adult management and financial discipline to an organization that clearly lacked it, she did not possess the recipe for the "secret sauce" that would enable Yahoo to monetize its enormous web presence and traffic generating ability. A convoluted deal with Microsoft on Search remains what is possibly a classic tech oxymoron-a convoluted deal with Microsoft.

As a closing thought, we think it is important to understand the practical limits of any "we only invest this way" statement. We strongly prefer to invest alongside people whose incentives are properly aligned with our position-which is generally that of a common shareholder-and who have a demonstrated track record of acting rationally on our behalf. But there are times when the degree of valuation discount-which may stem from investor disgust with present management-is so great that the risk of the possibility of another inane corporate venture or further mediocrity is deemed to be acceptable. And, as a number of CEO's have found recently, running a public company does not provide the job security of the Supreme Court.

(c) Cove Street Capital

www.covestreetcapital.com

         
 

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