During his recent interview with Tobias, small cap value manager Eric Cinnamond discusses how value investors can find opportunites in cyclical commodity stocks but it’s important to use a different valuation method. Here’s an excerpt from the interview:
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 Buffett’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 a… 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 thing we were 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.
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