(Ep.18) The Acquirers Podcast: Eric Cinnamond – Small Value, Absolute Return Small Cap Value Management

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Summary

In this episode of The Acquirer’s Podcast Tobias chats with Eric Cinnamond, Founder and Co-Chief Executive Officer at Palm Valley Capital. In 2016 he closed down a $400 million fund and returned money to investors because he believed he couldn’t find value for his clients. During the interview he provided some great insights into:

– What Is An Absolute Return Strategy

– How Do Investors Know When It’s The Right Time To Invest At The Bottom

– Why It’s So Important To Stay Away From The Herd

– Investors Should Not Be Concerned With Benchmarks

– How To Find Great Investment Opportunities In Closely Held Micro-Caps

– There’s A Lot Of Value In Commodity Stocks, But You Have To Use A Different Valuation Method

– What Should An Investor Do When A Stock Goes Against You?

– Investors Should Keep A Buy List Of Potential Opportunities

– What Was It Like To Navigate Through The 2000 Crash

– Great Value Investors Have A Willingness To Look Stupid

The Acquirers Podcast

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Full Transcript

Tobias Carlisle: You ready?

Eric Cinnamond: Yeah, let’s do it.

Tobias Carlisle: All right, let’s do it. Hi, I’m Tobias Carlisle, this is the Acquirers Podcast. My special guest today is Eric Cinnamond. He’s an absolute return small cap value fund manager with two decades of experience. He returned capital in 2016, citing a lack of opportunities in the market. He’s just relaunched a new firm and a new fund. We’re going to talk to him right after this.

Speaker 3: Tobias Carlisle is the founder and principal of Acquirers Funds. For regulatory reasons, he will not discuss any of the Acquirers Funds on this podcast. All opinions expressed by podcast participants are solely their own and do not reflect the opinions of Acquirers Funds or affiliates. For more information, visit acquirersfunds.com.

Tobias Carlisle: Hi, Eric.

Eric Cinnamond: Hey, Toby, thanks for having me.

Tobias Carlisle: My absolute pleasure. I’ve been really looking forward to this conversation with you. Can you take us through the process of deciding to shut down the fund in 2016?

Eric Cinnamond: Well, it started the year with the precious metal miners doing very poorly. And that’s really where I was focused on the equity side. And believe it or not, they worked out and they worked out very well. And many of the 50 cent dollars were reaching fair value. This was in the spring of 2016 and as they approached fair value, as an absent term manager, what you do is when they reach fair value, you don’t own over valued security. So I started to sell those and cash reached very high levels, almost near 90%.

Eric Cinnamond: And the remaining equities that I own were fair value at best. There wasn’t an adequate absolute return going forward. So sold many of the miners, was in the process of selling those. Cash reached extreme levels and the future did not look bright as far as absolute returns. We’re getting 0% on cash, that’s before fees. So I thought the best course of action was to return capital. And that’s what I recommended and the firm went along with it. And we returned over $400 million.

Eric Cinnamond: So, really, I shut down an 18 year track record, so that was another very difficult decision.

Tobias Carlisle: So why shut down? Why not just carry cash, try and do something else, maybe reduce the fee or something like that?

Eric Cinnamond: That was possible and we discussed that. However, I didn’t have confidence in the end of this cycle. Rates were at zero, there was still global QE, and I didn’t a lot of late cycle signs that would indicate that we were approaching near the end of the market cycle. I’m not on a market timer, but you have to be aware of where you are on the cycle. And to me, we weren’t there yet. And I thought, “Well, this could go on for several years.”

Eric Cinnamond: And I knew holding that amount of cash for several years, not only would it not help our investors, but it would gradually ruin my track record because you’re getting 0% of three years. That just wasn’t very appealing to me. So I thought, again, the best course of action was returning capital, but it was a very tough decision.

Tobias Carlisle: Yeah, I can imagine. I think you’ve probably been proven right, that it wasn’t the end of the cycle. And valuations, if anything, they’re probably more stretched now than they were then. So why relaunch a new firm and a new fund? The firm is called Palm Valley Capital Management and the fund is Palm Valley Capital Fund, and the ticker is PVCMX.

Eric Cinnamond: Yeah. I mean, this has got to be worst time to launch your absolute return strategy. There’s not a lot of demand for our type of investing, but there’s some special circumstances that occurred, really, in 2018 where a friend of mine, very bright portfolio manager Jamie Wiggins, was let go as an absolute return manager. And Jamie and I talked about it and I had no intention of coming back until evaluations improved. Jamie’s more of the mindset let’s launch before the cycle ends so we can take advantage of all the opportunities. It was a good argument, but the argument that persuaded me most was really just being around the same like minded investors.

Eric Cinnamond: That would be new to me, where the firm would be a pure, 100% absolute return focus. And with Jamie and our other partner, Frank Martin, who’s another very experienced absolute return manager. He’s written a couple books. And, I mean, when I was growing up as an investor, I used to read his annual reports. All I remember back then was they were so long. They were like 100 pages, but they were a very good summary of the year. So Frank was our financial backer, and we had Jamie who a very bright absolute return manager, and then myself. So each own a third of the firm and neither of us could envision another chance or opportunity for us to work together.

Eric Cinnamond: I knew Jamie wouldn’t be around for long, so we decided to launch. And it had been two and a half years, we’re on three by the time we launch, since I returned capital or recommended a return on capital. And things have changed. I mean, short term rates are higher. We’re getting 2.4% now in T-bills instead of the zero, so that’s better. And also, in 2017 and especially 2018, and I wrote about this in my blog, documented this for over a year, there began to be more late cycle signs. Where in 2016 I saw practically zero.

Tobias Carlisle: What are you seeing in terms of late cycle?

Eric Cinnamond: I’m seeing tightening in labor, I’m seeing a rise in corporate cost, in capacity utilization improving. You’re seeing certain industries that have extreme capacity constraints. Transportation is huge, so these sort of variables or instances of late cycle, indicators were not there in ’16. And they were growing in ’18. I still don’t know when the cycle ends, but I was becoming much more optimistic that we were getting closer. So that helped me as well. And then we’ll remember in 2018 in December, the Russell 2000 fell 20%. And I was so excited.

Eric Cinnamond: I was like, “I can’t believe this.” That we’re launching right before this thing is. And then, of course, we had the U-turn with the fed. And it wasn’t like things were cheap then, it just was going the right direction. So they took it all away just immediately, and so now we’re back to holding T-bills and just waiting this thing out.

Tobias Carlisle: That was a funny period. I had a lot of people asking me is this it, is this the bottom? And I always say that that’s the mistake, is just to shoot your bolt right at the very beginning of the collapse and not have any dry powder left when there’s real value around.

Eric Cinnamond: I know, but that’s what you want to do, right? I mean, it’s been so long, really, since QV3 is when things got a little nuts on valuations. I mean, more than a little. Yeah, I think that’s one of the biggest risk at the end of the cycle, is to get invested too early. Valuations are so extreme in small caps. If you get a 20% decline, you’re going to be so relieved you didn’t experience that 20%. You’re going to want to get invested, but of course, valuation wise you could still lose another 30%, 40%, maybe even 50%. So you have to be careful not to be a little …

Eric Cinnamond: You’re going to be a very, very anxious to get invested, but our strategy is to wait until we get some real discounts and not relative discounts, which is what you were starting to see at the end of 2018.

Tobias Carlisle: It’s one of the funny things about investing, that reverse compounding. I always point to the 1929 crash and say, “If you waited until you were down 80% and then you invested at that point, and the market proceeding down, it bottomed 90% of the peak.” So even if you waited at 80%, you were down 50% in that 80% to 90% range. Better than 90%, but it’s still a big loss to take. It’s extremely difficult to turn. So just can you tell us a little bit about your process and your strategy in the mutual fund or in the firm?

Eric Cinnamond: Yeah, it’s an absolute return strategy. And that means a lot of different things to many people, but we have a specific goal we’re trying to achieve. We say attractive returns over a full cycle, but our actual absolute return goal is 10% to 15% on our equities. So it’s not just the goal, that’s actually what we use in our discounted cash flow models. So you’ve got cash flow over K minus G. Our K is 10% to 15% with a 10% being a lower risk business and a 15% we’re requiring a higher rate of return.

Eric Cinnamond: In the cash flow we use, we use a normalized cash flow because in that sort of return investing accurate valuations are very important. You don’t want to make a lot of mistakes. So we’ll use a normalized cash flow. We don’t want peak, we don’t want trough. We’re still beating cycles. I know we haven’t had a cycle in a long time, but we’re still there. And then the growth rate, we use a 2% to 5% growth rate because these are more mature businesses. We’re not buying biotech companies, startups. These are just fuddy-duddy market leaders, mature businesses. They’ve been around. The average age of a company on our possible buyer list is probably around 50 years old.

Eric Cinnamond: But they’re small caps because they’re just unique, interesting niche industries. So that’s our valuation model. It’s normalized cash value over our absolute return, required rate of return, minus our growth rate. So it’s almost a perpetual bond type valuation. If you have a $10 million free cash flow normalized and you’re requiring 15% for the business, and you have a 5% growth rate, really all it is is just capping it by 10% or 10 times free cash flow. All multiples are is K minus G, right? So that’s how we do our valuation process.

Tobias Carlisle: And your universe is up to $10 billion in market cap.

Eric Cinnamond: Yeah, $100 million to $10 billion.

Tobias Carlisle: And do you know roughly where your average falls out or do you know where you find most of the opportunities?

Eric Cinnamond: When I was running a considerable amount of money, it was about a billion dollar average. Now that we’re running very little, we’re just out of the gate and we haven’t raised a lot of money. We’re going to gravitate towards the lower market caps. What we’re trying to do right now is stay away from the herd. When this cycle ends, we don’t want to be where people are being forced to liquidate. And that is going to be the ETFs, the passive funds, the index huggers, and all those small cap funds that have 100 names.

Eric Cinnamond: We just don’t want to be anywhere near that when that happens. So the smaller market caps, outside of the ETFs, we are finding value and that is because they haven’t been driven up by the flows, to the ETFs. So those market caps we’re looking at right now are more closer to $100 million. And some of them are closely held. And so the flow’s even less, but what’s nice about these is the balance sheets. The balance sheets we’re buying are incredible. Some are 30%, 40% of the market cap in cash. And that usually only happens with a closely held business where you have a family who doesn’t care.

Eric Cinnamond: When an analyst tells them, “Hey, you need to do something with that cash, you need to buy back stock and take on debt.” And the management’s closely held, they’re like, “Yeah, whatever. Go away. I don’t really care what you think.” And that’s the kind of companies we’re really gravitating towards right now.

Tobias Carlisle: What sort of industries are you finding opportunities in? What sort of companies, can you talk about names?

Eric Cinnamond: They’re just so odd ball companies. I mean, these little ones, they’re fun. I’ve missed this is because this is where I grew up when I work at the Evergreen Funds in ’96 and ’98. I grew up on a lot of these small, tiny companies. When I was at Evergreen, we were going to get a $6 million fund. And you really could buy these micro caps and they’re so unique. They might be industry leader, they’re just a tiny industry. And example would be Gencor. You would never guess what they do. They are the market leader in asphalt plants, right?

Tobias Carlisle: Right.

Eric Cinnamond: So they have about 40% market share of asphalt plants, right? Market leader. Their market cap, it’s about $170 million. So tiny market cap, but they have $115 million in cash and market securities, marketable securities. And they have 27 acres in downtown Orlando on the books back in 1983. So it was on the books for about $3 million. And if you drive down Orange Boston Trail, which is the street they’re on, and you look at the real estate prices on that road where a tremendous amount of traffic goes, you’ll find that $3 million is significantly undervalued. So you could just buy it almost for the value of the marketable securities of cash and the land.

Eric Cinnamond: And then you get the market leading business of asphalt equipment, which is extremely cyclical business, by the way. And cyclicality never bothered me, but it bothers some investors. An average asphalt plant costs about $4 million, right? So this is a very lumpy business, but 94% of the roads in the US are paved with asphalt. So it’s not going away. I don’t know if they’ll find a substitute for that. They haven’t so far. It’s closely held, though. The Elliot family has controlling interest, but great balance sheet.

Eric Cinnamond: Very inconsistent revenue and cash flows, but if you normalize it, they’ll generate $50 million at the end of the trough and they’ll generate $100 million in revenues on the peak. And we’ll normalize that and come up with about $4 million a year in free cash flow. And then we discount that back and we get a discount. It’s not huge, but when people dump small caps, they’re not going to be looking for Gencor. Well, they might. Actually, this one has some ETF exposure, or index exposure, but relative to most of what we’re seeing. Most of what we’re seeing, many of the ETFs, and index funds, and index funds own 20% to 50% of the flow.

Eric Cinnamond: So when they all get outflows at the same time, they have to sub. And we just don’t want any part of that wave. So that’s just one example, but it’s a very unique industry, very unique business, and extremely different balance sheet because, as you know, the corporate balance sheets right now are a disaster. When I think back to 2009 and March, the last time I got aggressive and fully invested, the balance sheets were so much better. I mean, so much better, especially with the cyclical names. Now, when the cycle ends, I think it’s going to be much more difficult to get aggressive quickly because the balance sheets are just not there.

Eric Cinnamond: How are you going to survive the cycle with these ’11 balance sheets? So in the next recession, next end of the market cycle, it’s going to be a lot more difficult than ’09.

Tobias Carlisle: Fortunately, the fed has completely eliminated the business cycle. So you’ll never need to worry about that again.

Eric Cinnamond: Of course. I keep forgetting.

Tobias Carlisle: I love that idea, though. That’s exactly the kind of business that I like. Basically, where you don’t have to pay very much for a business and it’s a cyclical business, and you try and buy it a little bit below where the average falls out. And then as it improves, you get a good return out of it.

Eric Cinnamond: Why do you think cyclicals are not appreciated by most value investors?

Tobias Carlisle: Hard to model. Extremely hard to model.

Eric Cinnamond: Yeah.

Tobias Carlisle: And I think …

Eric Cinnamond: They’re considered poor businesses.

Tobias Carlisle: Right.

Eric Cinnamond: But my point is if you generate zero and you generate $15 million on the peak, what’s wrong with that over a whole cycle? Instead of just as 7% consistent growth? It’s the same thing mathematically.

Tobias Carlisle: I agree. Graham talks about taking an average of years to try to find the average earning power over the course of the business, whereas Buffet’s talking more about a compounder. And I think if you’re looking for a compounder, then you ignore these companies. The problem is that there aren’t very many compounders around. Most companies are more cyclical.

Eric Cinnamond: And the compounders, the cycle have gotten so expensive because of 0% rates.

Tobias Carlisle: Right.

Eric Cinnamond: So it’s a tricky situation. You almost are forced. And I’m not but I remember the precious metal miners, when they got cheap. It was the only thing around. I didn’t want to be a miner analyst, but when you’re a value manager, you gotta go where the value was and extremely cyclical businesses. And no one, career wise, owned these things. So I think it has a lot to do with the career risk, as well.

Tobias Carlisle: I agree. I think at that time we were doing something similar. And what we were finding is that for a lot of these names, you could buy them for roughly the cash on the balance sheet. You didn’t have to pay much for the business, at all.

Eric Cinnamond: Yeah, I was finding minors selling at four times depletion. You could live off the depletion if you wanted, if they had a good balance sheet.

Tobias Carlisle: That’s another departure from many other value investors, that you are prepared to look at commodity type business. So what’s you’re approach when you’re doing something like that?

Eric Cinnamond: They did an attribution analysis at my last firm and one of the areas where I generate most alpha was actually commodity stocks. And the reason for that I believe is because commodity stocks are either very in favor or very out of favor. Rarely are they fairly valued. And you can buy them at significant discounts in the troughs. When oil was at $35 a barrel in 2009, or even a little less, that’s where I was finding most of the value. And remember in 2008? Oil was $140 a barrel, right?

Tobias Carlisle: Right.

Eric Cinnamond: And these energy companies were trading at three times replacement cost. And then March of ’09, the oil was around $30 a barrel and they were trading at significant discounts to replacement costs. So I can buy a barrel of oil in the ground for $10 a barrel, or I could buy an energy service company at .5 times book. And so what I was trying to do was trying to get a large discount to replacement cost of their hard assets. So I don’t view commodity stocks on cash flow. If you do that, you’re always going to buy them at the peak when they’re generating a lot of cash flow. And you’re never going to buy them at the trough when they’re losing a lot of cash flow.

Eric Cinnamond: But if you focus on the replacement cost of their assets, it’s a much stickier valuation because that doesn’t change as quickly as the price of oil, natural gas, or even the precious metals. So I’ve done very well historically buying them when they’re in recession, no one wants them, and they’re losing money. See, that’s another we taught in school, never buy a business that’s losing money, but it’s okay if they make money throughout a whole cycle. That’s how I view things, always over a whole cycle, never at the trough, never at the peak.

Eric Cinnamond: So I think that’s helped me a lot historically, buying them when they’re very depressed. In ’09, I was 20% energy, March of ’09, and that was very aggressive at the time. But that generated tremendous absolutely returns after that cycle ran its course.

Tobias Carlisle: There’s a nautic oil and gas investor, Christian CM, and he has the same approach. He says you buy them when they’re losing money and you sell them when they’re making money.

Eric Cinnamond: Definitely. But just think about buying the reserves at a discount. It makes it easier. Just like if you’re going to the gas station, instead of paying $3 a gallon, you’re paying $1.50. It’s the same thing, it’s just instead of that it’s at the pump, it’s just in the ground, the storage is free. But again, they have to have very good balance sheets because you don’t know how long the industry recession will last. And it doesn’t matter if you’ve got a 50 cent dollar if they go bankrupt, right? So very important, the balance sheets are extremely important for cyclicals.

Tobias Carlisle: So when you’re constructing your portfolio, how many positions, how concentrated are you prepared to get in any given name at inception, and how do you manage them as they go up?

Eric Cinnamond: We view things a lot of the times in terms of operating risk, financial risk. So operating risk being the cyclicality of the business, cyclicality of the cash flows, volatility of the cash flows. And then financial risk being the strength of the balance sheet. If I have a business with limited operating risk, limited financial risk, I’m very comfortable with a large weight if it’s at a discount. So those will be the 4% to 5% weights when you’re finding discounts. The cyclicals, they have to be at a very big discount and have a very good balance sheet if I’m going to have a big weight. But normally, those will be a lower weight if this is just an average discount. So I weight them by risk because actually return strategy, one of the main things we try to do is not make huge mistakes.

Eric Cinnamond: So if you have an extremely risky small cap idea that’s at a discount, it has a lot of operating risk, you better be sure you have a big discount and a great balance sheet to make that a bigger weight. But our weights will typically be 1% to 5%. 2009, the top 10 weights were about 40% of the portfolio. So concentrated when you have big discounts. In 2016, when I had small discounts, especially after the minors did well, those are 1% to 2% weights because I didn’t have any margin of safety. It was fair value. And when something’s fair value, the only thing you’re going to receive is that discount rate you’re using in your model going forward.

Eric Cinnamond: There’s no gap you’re going to close there.

Tobias Carlisle: Excuse me, I just lost my train of thought. Yeah, sorry. When a stock goes against you, do you buy more as it goes down, or how do you deal with something like that?

Eric Cinnamond: We do assuming our valuation isn’t in decline. If we made a mistake, because we do our valuations every quarter. And often, when a stock goes against you, it’s often after an earnings report. And if we messed up on our cash flow assumption, if we didn’t require a high enough required rate of return or we used too aggressive a growth rate, we will put that stock on probation until the valuation stabilizes. But if a valuation is in decline, we will not add to a position. And that has saved me I can’t tell you how many times from myself because instinct. When an idea you’ve worked on and you know is right, you know it’s right, and it goes against, you want to buy more. Your ego wants to buy more, but you do the valuation. All right, it’s lower. We’re going to wait a quarter now.

Eric Cinnamond: Give it some time, see if the temporary issues are actually temporary. And I’ve often found the balance sheets will deteriorate even further or they may panic and do an acquisition. It seems when a corporation is in distress is often when they do the wrong thing. So we might have to get to that period when the valuation stabilizes. We will definitely revisit and increase the weight.

Tobias Carlisle: I’ve heard on a Real Vision interview that you keep a list of about 300 names that you would like to buy at a price. And you just track the valuations and you don’t buy them until you get your price. So how do you manage that process and how many of those names are … It varies from period to period, but how often are you checking in with those names and how do you manage that process?

Eric Cinnamond: Well, we check the names everyday. It’s on a list. And we get the news everyday. And, really, it’s a quarterly process for the valuations. We’ll go through their quarterly reports, read their conference calls, and it’s on an Excel spreadsheet, the rough valuations. And it can alert you when those valuations are making sense again. But, to be honest, most of the names on the possible buyer list right now are extremely expensive. And the average PE is close to 30 times and the average price of sale is a little over two times.

Eric Cinnamond: So it’s not like I have to watch the buy list right now and today’s the day. We’re so far away from real discounts, from genuine discounts, that it’s not productive watching that list right now. But what’s very productive about the list currently, I find anyways, is monitoring the results of the companies, monitoring the conference calls, and getting a good feel of where we are in the profit cycle. Which helps us normalize cash flows. So we view the economy through the eyes of business. We call ourselves bottom up economists, which I really like. I think you can get a good, really, very accurate and timely view of the economy through following so many names.

Eric Cinnamond: Another thing that’s helpful by following all these names.

Tobias Carlisle: Just before you go on, what is that telling you about the cycle right now? What are your insights?

Eric Cinnamond: Well, 2018 was extremely entrusting. And it was the first time since the middle of 2014 that I saw very strong operating results of the companies very broadly. And that’s the first time, and like we talked earlier about some more end of the cycle signs, where companies were openly talking about cost pressures, price increases, inability to find sufficient labor. Things we’re really strong and then Q4 we had the market sell off. And this shows how correlated the stock market has become to the economy. Things became much more mixed in Q4 of ’18. And then Q1 I just finished and your listeners are welcome to email me and I’ll send them a summary of the buyer list highlights. It’s 108 pages, but I think a lot of people would like it.

Eric Cinnamond: But the beginning of Q1 ’19 started a little weak, but started to gain momentum at the end of the quarter. And I think that may have been what saved the quarter from a GDP perspective. And then it’s very correlated to the stock market because a lot of companies talk about a slow beginning, a slow Q4, and then a ramp up as there’s a little more clarity, really, I think with asset prices in February and March. So I think what it’s done is it’s proven how dependent we are now in asset inflation. And you can see with the home builders, too. The home builders were very weak. Not very weak, but weakening in Q4, early Q1, but then started rebound in the spring slowing season.

Eric Cinnamond: I joke with a friend of mine, actually Frank Martin, one of our owners. He does things from the top down and I view things from the bottom up. And I said, “Frank, I think we both have this wrong. We should just be looking at the S&P 500.” The next recession we have, I think we’ll just be down 30%, 40%, 50% on the S&P. And then we can claim we’re in a recession.

Tobias Carlisle: Is your benchmark the Russell 2000? Is that roughly the universe that you’re drawing from?

Eric Cinnamond: It is because we’re required to have a benchmark. Actually, I think it’s Morningstar something or another. Honestly, I don’t even know what our benchmark is because I don’t pay attention to it.

Tobias Carlisle: I just mean [crosstalk 00:29:18] sorry.

Eric Cinnamond: Yeah, but that’s the whole key to the strategy. You can’t be concerned about the benchmark because relative return investing, in our opinion, just isn’t the best way to get through a cycle. So if you don’t care about a benchmark, what do you care about? And what we care about is generating that attractive absolute return over a cycle. And specifically, the 10% to 15% required rate of return on our equities. That’s what we’re concerned about. And if you can’t achieve that, if 10% to 15% is not achievable because prices are too high, you just don’t do it.

Eric Cinnamond: You’re patient, you wait, right? But most people, most investors, most strategies have mandates where that’s not allowed. So that’s how we view it. We don’t obsess about relative performance. I was talking to a portfolio manager once and he said, “Eric, how are you doing today?” And I said, “I’m doing great, how are you?” He said, “No, how are you doing?” I said, “Doing well.” And he said, “How are you doing?” And I said, “I don’t what you’re talking about.” He said, “Relative to the wrestle.” I said I have no idea how I’m doing, but this is the obsession we have as an industry.

Eric Cinnamond: It’s not just quarterly, yearly, five years. It’s today at 2:30, however you’re doing. So it’s amazing.

Tobias Carlisle: [crosstalk 00:30:41]

Eric Cinnamond: It’s so short sighted out how registry has gotten, but we’re in a period now in this industry where if you underperform you get put in front of a board and have to explain yourselves. management committee. So it’s very difficult to run money this way. And we are very fortunate to have a firm now where we’re isolated from that. I can’t tell you how refreshing it is just to not have to deal with the relative return mindset.

Tobias Carlisle: I might have misspoken. So your universe is below $10 billion, but what does that roughly equate to in terms of a better known index. Do you know?

Eric Cinnamond: I think it would be similar to the Russell 2000, but a little higher. I think the Russell 2000 market cap might close around six to eight. And one of the reasons we want to go to 10 is obviously there’s more. The more the better to look through, but what I found in ’08, ’09, was many of my ideas I purchased in ’08, ’09, in the crisis, were mid cap stocks before. So I want to be familiar with the bigger caps when they come down to our core area of confidence. And that would be small caps. And I remember someone called me a journalist and they wanted me to comment on General Motors.

Eric Cinnamond: And this was in 2008, 2009. I said, “I’m a small cap manager. I think you got the wrong guy.” And he was like, “General Motors is a small cap now.”

Tobias Carlisle: How big was it?

Eric Cinnamond: I don’t know, but it had to have been below $5 billion.

Tobias Carlisle: [crosstalk 00:32:21]

Eric Cinnamond: On their way to distress, they became a small cap. So that can happen in a crisis. Again, some of my best ideas were mid cap stocks in the ’08, ’09 period. And we’re hoping for that again.

Tobias Carlisle: It was a $5 billion market cap with $200 billion in debt. On an EV basis, it was still a pretty good company.

Eric Cinnamond: Yeah, pretty big EV.

Tobias Carlisle: A mutual friend of ours, Jessie Felder, introduced us. And he shared a chart of yours, which I think was drawn from the Russell 2000 showing, the EV/EBIT multiples stretching back maybe 20 years or something like that. And it showed there was this hockey stick in about 2013 when valuations really went bananas. So can you just talk a little bit about that chart and what you deduce from that?

Eric Cinnamond: It’s a great chart. And I give credit to Jamie Wiggins. He’s the comanager of the strategy. He put that together. I had that similar with the possible buy list just using the average, but Jamie’s the median guy and he likes to use median. But I thought it was very good, but you’re right. 2013, QV3, that’s when things got crazy from a valuation perspective. And that’s really when I had a very good ’09 to ’12 combine, or ’08 to ’12, even ’07, but lagged considerably from ’13. And it was really 2013. I got smoked in ’13.

Eric Cinnamond: You couldn’t come up with genuine discounts. So we had a lot of cash and the market went crazy. So that’s one of the risks of the strategy, actually, is so that opportunity cost, being patient while the market is marching higher. No, that’s a great chart and it shows several things. Just that how you could easily lose half your money, just if we go back to average. I mean, I don’t think people realize when they’re allocating money to small caps and they’re buying ETFs that you are actually risking at least half of your capital just if we go back to normal.

Eric Cinnamond: The other thing I like about that chart is it uses EBIT. And the reason I like that is we have extraordinarily low interest rates right now for these small cap businesses, where people are lending small cap companies debt for an extended period at 4% and 5%. Many of these companies were almost bankrupt in ’08, ’09. And it wasn’t that long ago. Now, they’re getting a free pass almost on credit. So I like to normalize things and I would like to normalize interest rates if I’m going to value these companies. And the other thing is tax rates.

Eric Cinnamond: Tax rates are near 20% now, or 21%. You have to ask yourself, if we’re going to generate or have trillion dollar deficits partially because of these tax rates, are the tax rates sustainable? So if you believe tax rates are not normalized, they’re too low, interest rates are not normalized, they’re too low, it’s a pretty good idea to focus on either price to sales or price to enterprise value to EBIT because that weeds that out. It gives you a truer reflection of valuation in a more normal type of environment.

Eric Cinnamond: So that was a great chart. I wish I made it, but that was Jamie.

Tobias Carlisle: That’s music to my ears because that’s my favorite metric. That creates an unusual opportunity set, then, because if you do all that normalization, normalizing taxes, normalizing interest rates, and normalizing earnings for peak cycle, there can’t be much left that’s undervalued, if anything.

Eric Cinnamond: No. And that is our problem. So, again, returning capital is 16% because we’re not finding value. To be clear, we’re not starting a fund now because we’re finding value. Actually, there’s less value now. I mean, there’s just no value except outside of the benchmarks. We’ve talked about the lower market caps without the ETF exposure. There was some unique situations. We’re going to own a handful of those, but our main goal at this point is to be defensive and then get aggressive. So we can’t do really well on the absolute return side until the cycle ends.

Eric Cinnamond: But we’re so optimistic that when it does end, it’s going to be wonderful. And for the patient investors that have waited so long, I’m just so excited about what is in front of us. And each day that passes, I know we’re getting closer. So it’s a neat period for us. We’re all really excited. We were waiting in T-bills and some wonky small caps that are just fun to follow. So it’s a neat little portfolio. And we think we’re positioned perfect for the end of the cycle. The key for us, we talked about this earlier, too, is when prices start to make sense again, or get it close to that, is how we respond, and how quickly we respond, and do we allocate capital too quickly or too slowly.

Eric Cinnamond: So this is going to be a tricky end of the cycle. I don’t think this is going to be as easy as ’08, ’09, when there were so many good balance sheets you could just throw a dart and make money on a good balance sheet business that is down 60%.

Tobias Carlisle: I commend you for the approach. It’s an incredibly disciplined one and a difficult one to do for the fact that James Montier, who’s an analyst at GMO, he wrote this great paper about financial repression. And he said you’ve got two choices and they’re not great choices. One of them is if you think this is going to persist for a really long time, and he had some data that showed that these things can last for two or three decades, which made me a little bit nervous. If you think that that’s the case, then you need to be fully invested in wherever you can be.

Tobias Carlisle: You think that’s my bust right there or you think that at some stage we get the normalization or we get our crash basically. And then you take your opportunity to do it then. And honestly, I think that a crash is much more likely, but I don’t know.

Eric Cinnamond: Well, and we’re not 100% confident, either, but think about it this way, even if it’s a 50% chance, how are most people positioned right now? I would say 95% of people are positioned as if there’s never going to be a recession again, never going to be a bare market again. You’d think it would be a little more balanced, so hopefully with our strategy we’re at least providing people with an option. If you want to diversify away from that fully invested mentality, but that’s our business.

Eric Cinnamond: Our industry, fully invested is a mandate for many. They don’t have a choice. There’s a lot of major analysts that believe small caps over value, but they can’t hold cash or they will get fired. I mean, there was a portfolio manager on Bloomberg TV last night saying that he was going to derisk his portfolio and move cash from 1% to 5%. And I was like, “Whoa.”

Tobias Carlisle: Is that selling a position? He sold something.

Eric Cinnamond: He sold something, but that’s the mentality now. People have been burnt so many times from being conservative. And even if they believe things are over valued, if they invest that way, they have lost their job, many people, or shut down funds. So it’s extremely difficult. And that’s what happens at these cycles and why I don’t believe it’s perpetual, is money or capital is taken away from people like us who believe in cycles. And we don’t believe in over valuation will persist indefinitely. And eventually, that capital is fully allocated to one side. And that’s the risk takers and the people that are aggressive near peak valuations. There’s just no more capital to take from people like us.

Eric Cinnamond: I was running a billion dollars at one point and I don’t even want to tell you what I’m running right now.

Tobias Carlisle: Big opportunity set.

Eric Cinnamond: We’re tapped out, they’ve taken it from us. And I guarantee it didn’t go in a T-bill, so they took it. It’s probably fully invested ETF somewhere.

Tobias Carlisle: It’s been a very tough decade because there was a wobble in 2012 that didn’t really turn into anything. There was a wobble in late 2015 that looked like it really could be the thing, but then the market took off in 2016. And then, again, last year, there was that down 20% bounce like a golf ball off a concrete path and just took off again. So how do you manage through a period like that? You’ve stepped away from the table, but if we see that again, what do you do?

Eric Cinnamond: Well, I think that the three years off have definitely helped me. I’m just stepping away from it for a while. And I didn’t lose anything for waiting. Prices kept getting more expensive, but you’re right. I mean, every dip is bought, every dip is rewarded. And of course we know why, it’s central banking and their continuous effort to keep asset inflation growing. And there’s so much at stake. I mean, they’re going to go down swinging, so you have to anticipate further policy intervention. It’s going to be aggressive, so that’s part of the deal.

Eric Cinnamond: But one day, I’m still believing in cycles, and markets, and free markets. I think they’re bigger than governments. And I don’t know what’s going to happen or when, but to me, just the thought of creating value without sacrifice, or effort, or creating money. That doesn’t make sense to me. How can you create something indefinitely without making a sacrifice or effort in be considered wealth? So I think at some point there will be unintended consequences. I’m seeing it now with cost pressures and inflation. I know it’s not showing up in the data, but you’re seeing it with corporations.

Eric Cinnamond: So I’m optimistic in cycles and I’m optimistic that human nature hasn’t changed. And we will have a recession again. We have a lot of debt. A lot of things that have gone on this cycle that are very reminiscent of past cycles, where human psychology extrapolate. That’s the thing about these cycles, we just extrapolate what’s going on today so far in the future, but the future is not like today. It’s going to be different. And I don’t know how different, or what the catalyst will be, but to assume that everything is going to be same, and that every dip will be rewarded, and that every central bank intervention will have the same result, I think it’s being very naïve and I think goes against history.

Eric Cinnamond: So I’m still in the boat of cycles. I know I’m in a minority. I mean, what are your thoughts on this?

Tobias Carlisle: Well, I think there must be a cycle. I don’t have any more evidence than anybody else, but there’s been constant central bank intervention not just from the US Federal Reserve, but from the BAJ, and the ECB. And they’ve basically been handing it off one to the other pretty consistently for the last decade. And they’ve been running it like we’re in the middle, in the very depths of the recession. And that’s the thing that makes me most nervous because I keep on looking around and it looks pretty good to me. [crosstalk 00:43:59]

Eric Cinnamond: Exactly. It makes no sense.

Tobias Carlisle: What do we do if we actually go into recession?

Eric Cinnamond: I mean, we’re GDP at 3%. Companies are having difficulty finding qualified labor, [crosstalk 00:44:08]

Tobias Carlisle: Ultimate low unemployment.

Eric Cinnamond: I was reading a conference call this week. Was it Patriot Transportation? They had to shut down a transportation hub in North Carolina because they couldn’t find enough workers. And here we are, the market is pricing in a rate cut. It’s like what is going on.

Tobias Carlisle: And don’t worry. Everybody relax.

Eric Cinnamond: Yeah. You look at the economy, look at the companies, and you look at the tightness in the labor market, and then you see the narrative forming for a rate cut. And it’s almost like they’re panicked almost to keep asset prices inflated somehow, some way. And that’s, to me, desperation. And I just don’t know if that is a long term policy. This desperation of maintaining asset prices, I remember March of 2000. I came into work one day, I mean epic bubble, epic technology bubble. It went up every day. Every stock I owned went down, every technology stock went up by a lot.

Eric Cinnamond: And I came into work one day and the internet stocks were crashing. And there was no reason. It’s just you came into work one day and everything changed. And once it changed, there was no going back. The psychology shifted and it was over. The technology bubble popped. And there was no warning, everyone that owned them, all my friends that were millionaires on paper. But it just happened immediately. And no one’s thinking that will happen, right? I mean, you just walk in one day and you see the bond down five bucks because the bond market’s revolting, or the currency markets in disarray. I don’t think anyone’s anticipating that, but sometimes that’s how cycles end, without notice and they can be violent.

Tobias Carlisle: What was it like managing through a period like that? There aren’t really that many people who’ve been around in the markets as long as that, that they were managing through that late 1990s bubble. On one hand, you were finding the kind of stocks that a value investor loves to find under valued good business, throwing in flux of cash flow, but they just weren’t going up. Whereas you had these other pretty junky businesses that were running to the moon.

Eric Cinnamond: Yeah. My dad used to say if it’s not one thing, it’s another. But I’m telling you, things were so cheap in ’98, ’99. There was a lot of value in small caps. So you had a fully invested portfolio of these wonderful businesses generating cash, selling eight to 10 times already, and you get big dividends, and it was just wonderful for a value investor. But they went down everyday. I was an idiot and technology stocks were up 80% in ’99, 80% plus and I was down 8%. So that was the first time in my career that …

Eric Cinnamond: Before that, I thought I was a genius because I had the profit cycle from ’93 to ’97 bailing me out. And I thought I was a genius because nothing went wrong. But all of a sudden, I became this idiot that didn’t understand investing. And I went to the dermatologist because I had a piece of hair missing on the back of my head because of the stress. My immune system was eating my hair follicles.

Tobias Carlisle: No kidding.

Eric Cinnamond: Yeah, no kidding. And I went to the dermatologist and like, “What’s stressing you out?” And I said, “Have you seen E-toys?” I said, “It’s $85. They’re not making any money.” It’s like $100 million market cap. And the dermatologist was about to send me to a shrink. But he said [crosstalk 00:47:42] if you don’t stop obsessing about this technology bubble, he said you’re going to lose every hair on your body. I said, “Great, that’s what I wanted to hear.” So the technology bubble popped and all my hair grew back. And then did very well in 2000, 2002, because all those discounts.

Eric Cinnamond: Not only did they not go down in the bare market of 2000, 2001, 2002, they did very well. So I had great performance after that, but I was a very difficult period to get there. And then, of course, the housing bubble was similar, but a lot more cash because valuations were much broader. And then this cycle, we have to hold even more cash because I don’t know who termed the everything bubble, but I think it’s a great term. I wish I came up with it, but I think that pretty much sums it up. We have to own a lot of cash this cycle, too, because everything’s so broadly over valued.

Eric Cinnamond: These rotating asset bubbles we’ve been living through all have a unique set of challenges. They’re all similar to one in respect and they’re tied to policy, but they all behave a little differently. So you start to position differently for each one. You can’t just hold cash for each one. Holding cash didn’t work in ’99, owning an under valued equity’s worked great. So each one you have to adjust.

Tobias Carlisle: It’s been one of the maddening things about this cycle has been the … I forget who said it. It’s Pittlelynch or it’s Graham who said something like you find the thing that you like … Probably sounds more like Lynch, you find the product or whatever that you like. And then you don’t just go and immediately buy the stock. What you do is you go there, and you find the company and you do and evaluation on the company, and you see if it’s something that you want to buy. And that’s how you create your portfolio. That sounds more like Lynch.

Tobias Carlisle: But this time around, if you did that second step and you went and found a valuation that kept you out of Facebook, Amazon, Netflix, Google, because that’s the most maddening thing about this one. I’ve got a friend of the firm, Phil Backett, exponential ETFs. They have American customer service ETF, where basically they can judge the earnings a quarter ahead roughly based on the sentiment of people who buy these various products. And they can map them to the products. And there’s a competing ETF in Europe that does something similar, except they do another step, where they go and then do evaluation.

Tobias Carlisle: And so the one that doesn’t do the valuation massively outperforming the one that does.

Eric Cinnamond: Of course. The last thing you want to do right now is do a valuation and stick to it. It’s not very helpful. I was talking to the comanager yesterday, he was working idea and he’s like, “It looks like it’s a discount right now.” I said, “Stop right there. Don’t do anymore work because I know you’re going to find something and we’re not going to be able to buy it.

Tobias Carlisle: It’s been … Sorry.

Eric Cinnamond: Valuations have not been helpful in anything the past five years or so. It’s been a hindrance.

Tobias Carlisle: Being a valued investor …

Eric Cinnamond: But what bubble has that not been the case, right? You can do the same thing with real estate, and text docs, the other cycle. But in the end, it was everything, right? Not over paying was everything at the end of the last two cycles. So we’re sticking with that, that overpaying is the largest risk to investing. And historically, that’s always been the case. If the change is the cycle, overpaying is rewarded for the next 20, 30 years, then we’re all done. Is done, then it’s over, but we’re going to stick to that.

Eric Cinnamond: We’re going to go down swinging.

Tobias Carlisle: It’s been a very rough five years for valuations just because it’s been such a long cycle where value hasn’t worked. I think it’s the longest that I can find in the data. It’s sad because it’s meant that a lot of value investors have left the … Everybody’s just shutting down.

Eric Cinnamond: Well, who do you respect now? I mean, I’m having trouble finding people I respect in the industry. A lot of them have disappeared, some of them have passed away, and some of the greats I just scratch my head sometimes what the things are saying. So they’ll say one thing and then invest differently. So I just feel a little … And this is what’s nice about our new firm, is we’ve got three absolute return managers who are very like minded and very true to their discipline. But I’m finding that class of people that got the technology bubble right, people that got the housing bubble right.

Eric Cinnamond: They’re all different directions now. Everyone’s gone in so many different ways because the cycle’s been so long. I think after five years, you’re like, “I gotta change because this isn’t working.”

Tobias Carlisle: You’re out of a job.

Eric Cinnamond: You’re out of a job or mentally it’s hard to maintain that for so long. So I’m struggling now and this is why I love this alternate media you’re doing. And I know Jessie Felder does it and I think it’s great, but it’s nice because you can find that community where there’s still some people that think the same way or haven’t given up.

Tobias Carlisle: Can find the handful of weirdos who haven’t given in yet.

Eric Cinnamond: Exactly. It’s a support group. My name’s Toby, I still believe in cycles.

Tobias Carlisle: I do and value investing, which you’re a complete laughing stock if you believe in value investing. I always say this, there’s nobody from my vintage who’s famous because it’s just been … I mean, there are no well known value investors from my vantage beforehand. So there’s Ackmann, and there’s Iron Horn, Dan Lobe. And they’re all activists, but that was the cycle, too. But there’s really nobody who’s been able to establish a track record below those guys who’s in the market now.

Eric Cinnamond: Yeah, and credibility expires. I remember after a technology bubble, credibility high. By 2005, I was an idiot again. And then after the housing bubble, credibility high. And I’m back to being an idiot again. But the key to absolute return investing and discipline in investing in general is the willingness to look different and the willingness to look stupid. It’s very important. So if you’re uncomfortable with that, you might as well just go with the flow. So if you’re going to be a great investor, you can’t look like everyone else. It’s impossible.

Eric Cinnamond: I mean, all these consultants want lower risk, higher returns, but they want you to look the same while doing it. So it’s impossible. So you have to be different.

Tobias Carlisle: It’s funny the number of times that I’ve spoken to allocate. It’s even allocate as you allocate to value. And they say, “Here’s what we want.” You’ve gotta be looking for compounders, you’ve gotta be looking for moats, you’ve gotta be looking for higher return on invested capital. I had a call last night with a guy that was describing it to me. And I always say aren’t you concerned that you’re going to get 10 different investors that hold exactly the same portfolio.

Eric Cinnamond: That’s right. You’ve gotta be in a box. That’s one thing I learned after the technology bubble. We had great performance, we tried to sell it to consultants. And if you didn’t fit the mold, if you hold cash, or you don’t have sector weights, you almost have to build a portfolio if you want to make a lot of money professionally. You almost have to build a portfolio that you can sell, not how you believe it should be run. It’s two different things. And how are you a fiduciary in this market? I mean, how can you be a fiduciary in this market and be fully invested, right? I have a hard time with that, that whole concept.

Eric Cinnamond: But if you have mandates requiring you to stay fully invested, can you adhere to your fiduciary duty at the same time? I don’t think you can and that’s very interesting, especially for regulators when the cycle ends. There’s going to be a lot of questions to be asked and maybe some things to change where you provide managers more flexibility in this rotating asset bubbles to protect capital. It isn’t right now. There’s no focus on protecting capital, but there’s a lot of focus on keeping up with the benchmarks, right?

Tobias Carlisle: Right.

Eric Cinnamond: But that needs to change. And I know we’ve had two cycles where that should’ve already changed. But this one, because things are so broadly over valued, I really think we need to have a hard, really thoughtful discussion on this, on fiduciary duty and the conflict with these mandates, of being fully invested sector weights. Almost requiring you to stay committed.

Tobias Carlisle: And it’s so extended. So anybody who’s an adult in the room has a terrible track record because they’ve been underperforming and carrying cash.

Eric Cinnamond: Yeah.

Tobias Carlisle: We don’t know if you’re 50%, you’re 100% behind the market. What do you know?

Eric Cinnamond: Yeah. Well, I was very lucky. I cut my track record off of ’16. So I didn’t have to go through this. I was like, “Hey, it still looks pretty good. But if I went through it to ’19, it probably wouldn’t have held up so well, because I would’ve been all cash.

Tobias Carlisle: Must’ve been incredibly tough to walk away from that 18 year track record.

Eric Cinnamond: It was extremely tough, but I didn’t really have a choice. You either overpay or you don’t. And if you overpay, I would have more trouble with that than leaving the track record. And we’re not overpaying now, which is nice. We just don’t have many stocks. We’ve got a lot of T-bills.

Tobias Carlisle: Well, Eric, we’re coming up on time. If folks want to get in touch with you or they want to read what you’re writing, where do they go to find you?

Eric Cinnamond: We’ve got a website, Palm Valley Capital. And we’ve got a blog on there, still writing a blog which I was doing. I still keep track of my names, ’16 until now. So yeah, just go to our website and feel free to email me or give me a call.

Tobias Carlisle: And we’ll put your contact details in the show notes for the show. Thank you very much for the time, Eric Cinnamond.

Eric Cinnamond: Enjoy it. Thanks, Toby, so much. I appreciate it.

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