In this episode of The Acquirers Podcast Tobias chats with Eric Cinnamond of Palm Valley Capital. During the interview Eric provided some great insights into:
- Don’t Stress It, Press It – Tilting to Growth
- Value Investing Parallels Between The Late 1990s And Now
- The Stock Market
BubbleSnowball - Small & Micro Outperforms On Every Measure
- Choosing Silver Over Gold
- Opportunities In Energy
- The Secret’s Out For The Fed
- Passive Fund Selloffs Provide Great Opportunities
- Buying Compounders At Low Multiples
- Never Combine Financial Risk & Operating Risk
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Full Transcript
Tobias: Hi, I’m Tobias Carlisle. This is The Acquirer’s Podcast. My special guest today is the great Eric Cinnamond of Palm Valley Capital. We’ll be talking the Fed, we’ll be talking flows, we’ll be talking small value right after this.
[intro]Tobias: How are you, Eric? Good to see you again.
Eric: Great to see you, Toby. Thanks for having me back.
Tobias: My absolute pleasure. You got one of the best responses of any podcasts that I’ve put up, folks like the message, and I know that you’re well received every time you go in Real Vision as well. Just for folks who haven’t heard of you before–
Eric: [crosstalk] [laughter]
Tobias: For folks who haven’t heard of you before, what do you do?
Eric: Well, we run an absolute return strategy. It’s small caps. It’s very simple. We’re getting paid to take the risk, we will, and when we’re not, we don’t. We hold cash. We’re very different than most small-cap funds that are fully invested, and it’s worked really well over three cycles. But it’s very painful during certain periods and very rewarding during others, but it’s very different. We will be fully invested to 95% cash, depending on the valuations of our opportunity.
Tobias: I have spoken to a few other guys who we know mutually, and I know that we had an opportunity last year. In March, I don’t think, at any stage, it really got cheap. A lot of folks seem to think that was like a 2009 style bottom, but I thought it would that was just one of the more frequent drawdowns that we’ve had over the last sort of decade since then. I know that you got– it was very brief, but you got some way invested, and have you taken some of those positions off? What happened through that period?
Eric: Well, we were 95% cash or so going into 2020. The fund launched in April 2019. We were getting 2% on T-bills. Of course, the Fed eventually took that away from us as well as they pivoted and did the pre-event [unintelligible [00:02:33] asset inflation revert. Now we’re 90%-95% cash going into March. Of course, we had COVID. They say they don’t ring a bell before stocks crash, but I thought the bell was ringing for a couple months there, giving you a little warning that economic demand may decline.
But then March hit, and just small caps got cut in half. Small-cap value and benchmarks were down practically in half, and it happened very quickly, and liquidity completely evaporated, the bids disappeared, and that’s when we typically do well. It’s not the catalyst we wanted for sure, but it was a catalyst, nonetheless. Many of the high-quality, small-cap stocks we had on our possible buy list, we bought about 300 names. Went from extremely overvalued, to some got very interesting, and we were able to get half of the fund invested. I think we would have gotten completely invested if it were not for the Federal Reserve purchasing corporate bonds. I think that was the day that everything changed, when they’re willing to buy private assets, and our private debt.
Tobias: And ETFs.
Eric: We were on the way. I think if we had one more week of the turmoil, we would have been fully invested. We’re a little bitter that didn’t happen, but also very grateful for the volatility we had to at least get half invested. We ended up the year 19%, and average committed capital for the year was 27%. You think about the risk that we took much less than the average small-cap fund, and we were able to beat both our benchmarks. But again, we’re an absolute return strategy, so that’s not our goal, to beat the benchmarks, but, whatever. [chuckles] We did it in a very unusual way, just shows how the strategy could work.
Tobias: What are you looking for and what sort of sizing are you trying to get? What’s a full-size position for you?
Eric: Usually 4% to 5%. We’ve had that on a couple names more recent. I know when I was managing money in 2009, the last time valuations were very attractive. The top 10 holdings were about 40% or so, maybe a little more. So, that was sort of a concentrated portfolio. But when you’re in a period where small-cap valuations are extremely expensive as they are today, you don’t have those 50 cent dollars for the most part, the position sizes will be a little lower. The position sizes are built on discount and risk. If you have a really high-risk business, even if it’s a big discount, it might not be a 4% or 5% weight. Energy is a very good example recently. But if we have a low-risk business with a great balance sheet and a big discount, Amdocs, DOX is a good example, that will be more of a 4% to 5% position.
Never Combine Financial Risk & Operating Risk
Tobias: When you’re defining risk, you’re talking about the business strategy risk. You’re not talking about balance, you’re saying there’s good balance sheets, but there’s just something– it’s a commodity, and so you don’t really know where commodity is going to go, you just looking at– is it kind of undervalued on earnings power basis, average earnings per basis?
Eric: Yeah. Well, risk for us, as you point out, is partially valuation, but also for each business, we’re looking at operating risk and financial risk. We’ll have operating risks, volatility of cash flows, uncertainty of cash flows, and that would be like an energy company, it’s cyclical, industrial. Then, we’ll look at financial risk, and that will be maybe as a steady company with some debt, maybe think about like a constellation brands, some wine company that has some debt. We’re willing to take operating risk or financial risk.
We just never combine the two, because that’s when you can have a goose egg. Financial return strategy, which we’re really just trying to generate an attractive absolute return over a full cycle, you just can’t have companies go bankrupt. It’s just not a good look. [laughs] [crosstalk] That’s how we view risk.
Valuation, you point out a very good point, but also within the business’s financial risk and operating risk, I am a little more comfortable with operating risk. You’ll find out, maybe recommend some cyclicals, energy, again, it’s a good example. Jayme, the comanager, he’s a little more comfortable with financial risk. It’s a nice check and balance for both of us. We’re bringing something on maybe some debt, it’s like, “Oh, oh, oh.” And then I’ll bring on something with some operating risk, I go, “Wait, wait, wait.” But we both agree we’ll never combine the two. That’s helped so much in the past runs, the strategy.
Don’t Stress It, Press It – Tilting to Growth
Tobias: I read your latest blog post, your latest piece that came out on 29 December, and you were talking about a discussion that you had with a friend/colleague of yours. This is something that I have encountered many, many times. I want to talk to you about this a little bit, the drift in style. He’s gone from being a value guy, or maybe at the deep end of value to being a value guy at the growthier end of value or even a full-blown growth guy. It seemed like that made his life so much better. What are we doing?
Eric: Oh, so much better.
[laughter]Eric: If you want to be wealthy, if you want to sleep well at night, you don’t want to be a value manager.
Tobias: And that sounds great. That’s what I want.
Eric: Yeah. My favorite part about that blog post or the conversation with my friend, and he’s the one that brought it up was, he said, “when you go to bed at night before your value stock reports earnings, and you know that feeling you have? You know it’s just going to be bad.” You can’t sleep, you think about how bad it’s going to be, how much money you’re going to lose the next day. But he’s like, growth stocks, it’s totally a revelation to him. You make money the next day and you sleep well. It’s like you know you’re going to make money, you know the stock is going to go up.
I thought that was [unintelligible [00:08:37], but it’s also true. He has converted and very comfortable with it. He doesn’t rub it in my face, and I completely understand where he’s coming from. He’s got no family, a mortgage. To run money how we run it, you might not get paid. Jayme and I haven’t collected a salary in two years. There’s a lot of sacrifice that goes into running money this way. But to keep up is pretty easy. To do it, the decision is easy. I guess I shouldn’t say that. It wasn’t easy for him, but once he did it, it was a lot easier.
Tobias: It made his life better.
Eric: Once you convert, you’re like, “Whoa. Why was I a value investor to begin with? What an idiot.” [laughs]
Tobias: Isn’t that the question, then why not convert? Why not go and become a growth guy?
Eric: Sure. That’s a great question. [laughs] Maybe I should ask you that question.
Tobias: Well, I’ve thought about it a little bit. Here’s what I think because I haven’t been doing it for as long as you have, but I have been through a few cycles now. I’ve also seen the reverse where for a very long period of time, great companies put up great numbers and just drifted sideways and had a whole lot of volatility for about a decade.
Valuation at some point– the way I think about is that you do really get– I think about it like I’m owning the business. I’m going to get the return, that the business generates, I’m going to get the yield and whatever is reinvested in that business over a period of time. I’m not trying to buy it on what I think the market is going to do to that stock price. I’m trying to buy it on what return that I can see I can get from the underlying business. When I look at some of these expensive businesses, I think a lot has to go right for a long period of time for this thing to pay you back.
Eric: Yeah, no doubt. We have some names now in the portfolio we really like. Our cash has gone up quite a bit, but what we have in the portfolio now we really like. We have a company called Crawford & Company, it’s an insurance adjuster–
Tobias: Great business.
Eric: They improved their balance sheet considerably. It’s closely held, so no one cares about it. 500 million enterprise value about 350 market cap, generates 50 million a year free in cash flow. We’re getting 10% free cash flow yield. They’ve cut their debt in half over the past. Since 2017, they’ve reduced their pension obligations in half over the past five years. They’ve gotten absolutely no credit for the improved balance sheet, improved operating results. For them, they’ll do a lot better in periods where there’s a lot more claims, whether catastrophe, say a hurricane, medical claims, they outsource all of that, but it’s done well. The fundamentals have improved, the balance sheet is so much better.
One of my favorite investments are companies that improve their balance sheets. In theory, you should get dollar for dollar increase on your equity as you pay down your debt. Even more than that, because now your discount rate is [crosstalk] lower because you have lower risk in the business.
We’re having these names, especially the closely held ones I’ve noticed, where they are improving, no one cares. They’re deep value stocks. I point to the passive funds, I just think, especially this closely held names, I don’t think a lot of their float is in these passive funds. It’s all about flows right now. It has nothing to do with fundamentals in this business paying off half of its debt. But in the old days, if you’ve reduced your debt that much, you would get rewarded as an equity holder.
Tobias: Are they buying back stock? Are they taking advantage of it?
Eric: They are. The dividends nice too. It’s a little over 2% dividend. But it’s a good example of sticking to value, even though it’s not working because as you’re pointing out, you get the dividend and the business is growing, but for us, more important, the balance sheet’s improving.
Tobias: And you’re owing more and more of it.
Eric: Now we see real value for shareholders, it’s just not in the stock price. The value of the business, [unintelligible [00:12:54] leverage, clearly growing.
Tobias: It’s just not a sexy growthy business, and that seems to be– the thing that the market wants at the moment is incredibly high growth rates, even on a top line, even if none of it ever falls to the bottom line, or it will ever fall to the bottom line or will ever show up in free cash flow. They just want the growth. I guess the market goes through these [unintelligible [00:13:15].
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Buying Compounders At Low Multiples
Eric: If you’re 10 times free cash flow and you’re– name your multiple now. It’s just outrageous, 50 times. If I’m at 10 times free cash flow, and I can compound that 10% and reinvested in the business or pay down debt, it’s so hard for a growth business at 50 and 100 times earnings to catch up because we’re so far ahead with the amount of free cash flow yield we’re receiving. If you’re receiving 1%, or 2% free cash flow yield over here, think about how long it takes that coupon to catch up to the 10%. The 10% is still growing. I’ve done all this in ‘99. This is a total flashback where the same things are going on, but there’s some differences, we could talk about that too.
Tobias: Well, let’s talk about that. Just before, I sometimes I think that in the universe that I spend most of my time looking at this, there’s equivalent stocks like AutoZone or O’Reilly where, I like the fact that they stay cheap for longer because they just buying back stock hand over fist all the time, and so you’re getting your return. Even if it’s not necessarily manifesting in the stock price, the return is– the intrinsic value, it’s compounding and going up pretty materially.
Eric: Yes, but it compounds even better when it’s a low multiple for you.
Tobias: When it’s cheaper, yeah.
Eric: For you.
Tobias: That’s right.
Eric: I find that interesting. Your starting point as a value investor is so much more attractive. If I can grow at 5% a year, compound that 10% free cash flow yield, it’s so hard for 1% coupon, 2% coupon to catch up to argue. [crosstalk]
Tobias: It has to grow very, very rapidly for a very long period of time.
Eric: Yeah, and then with that 10% coupon, you could do so many more things than the 1% to 2% coupon can do. Of course, the catch of that If you have unlimited capital, which a lot of this 1% to 2% coupons do–
Tobias: It doesn’t matter.
Eric: –it throws– but over time, they will not have that unlimited capital at that cost of capital indefinitely, at some point that hurts.
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Value Investing Parallels Between The Late 1990s And Now
Tobias: What are the parallels and the differences between the late 1990s and now?
Eric: Well, I think the similarities are that value is very cheap relative to growth, very cheap. The biggest difference is the components of value. Now, in ‘99, I had– you look at the Russell 2000 value, there were some really high-quality small-cap value stocks in there. There was Church & Dwight, the market leader, or Armand Hammer, J & J Snack Foods, JJSF, Lancaster Colony, they do dressings and bread, Gorman-Rupp, one of my favorite pump companies, sewage pumps, the big blue pumps, you see at construction sites. Oil-Dri, the market leader in cat litter. God, there’s so many, [unintelligible [00:16:11], Scotts Miracle-Gro. I can go on and on.
Tobias: It’s so sexy.
Eric: [crosstalk] -everyone uses. 50, 60 times earnings– [crosstalk]
Tobias: Well, it’s not expensive.
Eric: At least Church & Dwight, they use Armand Hammer for almost everything. I don’t know if you can put WD-40 in toothpaste. [laughs] I think there is a limit there, but it is at 60 times earnings. All these traditionally small-cap value stocks back in the 90s and early 2000s, have had multiple expansions that have been unbelievable. You’ve gone from 10 to 15 times– Boston Beer’s another one. I bought Boston Beer at $9 in 2001, I believe, maybe 2000, it’s now at $900.
Tobias: I thought it got interesting a couple of years ago, I think it got cheap a couple of years ago, but then I didn’t buy it at the time, and I went back and looked at the chart, and I was stunned at how much it had gone up.
Eric: That’s probably the should have, could have, would have of my career. I did well on it, but if I held it–
Tobias: Yeah, you wouldn’t be doing this. [laughs]
Eric: Wouldn’t be doing this podcast with you.
[laughter]Eric: The composition of value completely changed. Now, those kind of companies are huge premiums to book, huge P/Es, 30 to 60 times, price and sales three to six times, very expensive. That is partially because of the multiple expansion we have, which of course, any of these perpetual bond-type companies, which these, are very high quality, you’ve had low rates. But 10, 11 years of this rate environment has caused people to just– you can slap any multiple on these and it’s still better than zero. So, then what’s left in value?
Well, extremely cyclical companies generate trough results, energy, financials. Financials is a huge component now. I think the quality of value has gotten worse, even though value’s still cheap relative to growth. In 1999, it was high-quality value cheap to growth. It was just so much more comfortable for me to buy the market leader cat litter than a bank in Texas trading at 1.1 times book that may or may not have a pretty good commercial real estate loan portfolio. The financials now are very interesting. I think some are cheap and they’ve moved recently, but I think it’s harder to get a high degree of confidence in valuation than the stocks in 1999. So, that’s the big difference.
Tobias: I think that’s borne out statistically too. There’s a AQR research paper that shows one of the things that– I think it’s a Cliff Asness paper on his blog or something like that, but he looks at the return on assets of that value decile, and they were better companies than the expensive stocks in that early 2000s or late 1990s period even though they were trading much more cheaply.
This time around, you do have to take– They’re not as good companies, they’re still way too cheap for the quality that you’re getting, but they’re not as good as the expensive companies. You can make an argument that even if you’re overpaying for the more expensive companies, the market still has the sort kind of right if that makes sense.
Eric: Right. No, that doesn’t make sense. You’ve actually looked into this. See, I just make stuff up as I go.
Tobias: Well, I didn’t look at it, I’m just–
Eric: I just see if my buy lists, and I’m like these can’t be value stocks anymore. That’s interesting to know that.
Tobias: What’s causing all these?
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Passive Fund Selloffs Provide Great Opportunities
Eric: These things go in cycles. I’m still a believer, these high-quality names are just so expensive if you’re growing 2% or 3%. What most of these do is grow at nominal GDP rates. It’s not exceptional growth. Organic growth is not there to support these valuations. We’ll just wait it out. You saw it in March, some of these names, like UniFirst, one of the market leaders in uniforms, another slow grower, but consistent. It got destroyed. Sykes is another one, public company market leader in call centers, that was another stock that got down to $24, 2.8 in free cash flow year, $2 in cash, no debt, just exceptional value. This again goes back to March.
What you had in March was the initial selloff. The high-quality value stocks or historically value stocks, they held up pretty well. It wasn’t till kind of mid-late March, where the bid disappeared, and that’s for us is like whoa. You had stocks down 5%, 10%, 15%, even 20% a day, where you could tell there was the bid was disappearing, liquidity was drying up. There was no one there on the bid. A few 100 shares will knock these stocks down. That’s when I said, finally, finally, passive is in trouble, because there were outflows, and you could tell the trading was so sloppy that they were selling into a market with no bid.
That’s when we got invested., and that’s when the higher-quality names got cheap. We bought Weis Markets, WMK. It had at the time $5 a share of cash, now has $8 a share in cash. It’s got down to 35, $3 a share and normalized free cash flow. This year, they’ll make $5 because of the pandemic, and $35. They own half their stores. We bought it below tangible book value, 4% dividend at the time, and it didn’t matter if people were selling. There was no bid. That’s what we do so well.
March was interesting with the high-quality. Talk about how expensive high quality is, they did get hit in March. That I think was a reflection of passive finally getting outflows. March was a test run. That wasn’t it. If anything, it’s caused people to believe, “You should buy every dip.” It has encouraged them. They didn’t really learn that lesson, but what we believe is that was a great test run, check everything you’ve done.
Look under the hood of your portfolios, how did these stocks perform, because that for a couple of weeks was what the end of the cycle we believe is what it’s going to look like when the bids disappear, and you can’t get out without moving the stock down significantly. Right now, I think, the liquidity in these illiquid names in small caps that we’ve been doing this for so long, it just feels like it’s always going to be there, but it’s not. Same with junk bond funds or corporate debt funds. It’ll be very interesting when the cycle ends to watch the passive investors try to all get out at once.
We’ve talked about this before, but that is going to be the great opportunity for patient disciplined investors, is when the passive funds have to sell because they don’t have cash. When they get outflows, they have to sell. We saw that in March, and it was glorious for disciplined value investors that had the capital to buy from them.
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The Stock Market Snowball
Tobias: It tends to be the two causes in your mind of what’s happening in the markets. First of all, it’s the Fed just pinning rates way too low for way too long, and everything else that they’re doing. Secondarily, it’s this trend towards passive where the flows drive the returns. I’ve got to ask, why do you really care whether the bigger companies keep on getting those flows and growing when– the absence of flows to the smaller companies creates these opportunities?
Eric: It does, but I would say it’s definitely been [unintelligible [00:24:29] to the smaller passive investors, smaller caps. Given the valuations, there has to be. The Russell 2000 troughed at 980 in March around, and it’s over 2000 now. Small caps got cut in half, and now they’ve doubled. [crosstalk]
Tobias: [crosstalk] Well, everything seems to stretch past where it was last year before the crash.
Eric: Oh, yeah. It’s crazier now than it’s ever been. [crosstalk]
Tobias: With everything going on, it’s amazing.
Eric: Oh, yeah. With everything going. NASDAQ in 1999 was up 86%. I was like, “This is crazy. It can’t get much worse than this.” Then it proceeds to go up another 2030 before it crashed. There’s no reason these markets can’t go higher. The large caps– people often view stock market bubbles as natural bubble. I like to think of it as a snowball. The beginning of the cycle, you’ve got a small snowball, and you’re rolling it up the hill, and it gets bigger and bigger and bigger and bigger. By the time you get to a very steep part of the hill, the snowball is so big, it needs so much more force, so much more capital to push the snowball up the hill. If you look at the Wilshire 5000 right now, the market cap’s like $40 trillion. And then if you look at total tradable debt securities, it’s like $60 trillion. So, now you’re about $100 trillion snowball.
Tobias: It sounds like a lot.
Eric: You’ve got the Fed buying $120 billion a month, and you’re like, everyone thinks, “Oh, that’s a huge number, that’s going to save us.” You annualize that, and it’s like $1.45 trillion, but that’s tiny compared to the snowball. The snowball is going to need a lot more if you’re going to keep pushing this thing up because the higher prices get on debt and equities, the bigger the snowball gets, and the steeper the slope gets, it’s harder and harder to push it up. Everyone that has this belief that the Fed can always be there for us, always manipulate stock prices, always keep the assets where it should going, I think they’re losing track of how big the snowball has gotten. At some point, you go $100 trillion, $150 trillion, what is $1.4 trillion? Even if they move it up to– what’s the balance sheet, $7 trillion? Were they going to make it 50 trillion? I don’t think so.
Tobias: Don’t tempt them.
Eric: [crosstalk] -dollars. At some point, that snowball, and every cycle has proven this, starts to roll back. There’s not enough capital to keep it up, and then it goes back and it crushes everyone trying to push it up. It goes all the way down the hill, and now the snowball is small again. That’s when Jayme and I come in. We have a small, small snowball, we start pushing it back up the hill, where we start to allocate our capital. We watch from safe distance at the lodge while we’re sipping our tea and watch the giant snowball that gets harder and harder to get up the mountain.
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Tobias: The nice thing that happens, though, when the market does that is that many of the current larger-cap stocks that probably don’t fit into your investable universe, might move back into your investable universe. Do you do you keep an eye on things that are outside that might come back?
Eric: Absolutely. We’ll follow a lot of mid-cap stocks just for that reason for them to come back to small caps. So definitely. At the end of the past two cycles we’ve been in, that helped us a lot. Just keep an arc. We had a little bigger range, 100 million to 10 billion, and part of that is to keep track of a lot of that, and even some that cannot go over 10 billion, we’re keeping track of those to hope one day to own those again as small-cap funds.
Tobias: What’s the biggest you can buy inside the strategy?
Eric: 10 billion
Tobias: 10 billion. Okay, so that’s getting up into– What’s your definition of small-cap, is it like, 2 billion bit bigger than that?
Eric: Well, 100 million to 10 billion. Average for us now is probably, I would say, 600 to 700 million. We’ve got quite a few [crosstalk] small that skew the number down. We still like the small caps, because they haven’t been really polluted as much with the passive funds. We still have several– Crawford, I think it’s a great name, great idea, but it’s a 350 million market cap, so it’s not for everyone. It has a little overexposure in the benchmarks. That’s what we want.
We have another one Protective Insurance, they’re 200 or so million, trading at 0.6 times book value. There’s some interesting ones in financial industries as well, trading at very large discounts, but they’re illiquid. This one is closely held as well. So, it’s kind of a double whammy. Our biggest holding is DOX, that’s a little more liquid, that’s quite a bit higher, but it’s getting close to our evaluation. The liquid ones are getting tougher and tougher to hold where the elegant ones haven’t really noticed the market’s up.
Tobias: What do you think it takes to turn the cycle because in the last few days as we’re recording this, pick your name for it, but there’s been protesters or rioters or a coup attempt, depending on your particular side of politics, and the market was up pretty strongly. It’s up again today. Clearly the markets not going to be a virus that’s going to wipe out a lot of us that didn’t really matter ultimately. A coup in the US doesn’t seem to really matter. What’s it going to take? An alien invasion, that might be bullish.
Eric: Well, that’s why I agreed to this podcast [crosstalk] let me know.
Tobias: I’ll tell you.
Eric: [laughs]
Tobias: I’ll tell you the– [crosstalk]
Eric: That’s the premium service.
Tobias: That’s right.
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The Secret’s Out For The Fed
Eric: I tell you, this fed, I love it, hate it. I mean, I hate it because it controls markets, it manipulates asset prices, it’s trying to take over free markets, but I love it because they always fail in complete chaos and opportunity, volatility when it’s over. It’s tough to know what causes this. If I had to guess, I would think it’d be the dollar. I just think, how can you create literally trillions of dollars without effort or sacrifice and assume at some point that doesn’t affect the value of the dollar? We had those PPP loans– operating environment really for Q2, Q3 did better than I expected, and a lot of that was stimulus, that was $500 billion, pretty much given up to companies. It’s a free for all. Then you had $300 billion in stimulus checks sent out. We just had another stimulus plan. If you exclude that, things would have been really bad. What’s the plan here? Just keep sending out trillion-dollar packages?
I’m actually in favor of this. The Fed has helped the one percenters or inequality has expanded considerably, wealth inequality. I believe if we’re really going to just benefit them, we should benefit everyone, and if you’re going to print money, send everyone a $20,000 check, every person in America, so that would be $6 or $7 trillion, which is about what the current balance sheet is. Double the balance sheet, but let’s make it fair.
Tobias: It’d be distributed more equally.
Eric: Let’s send it out to everyone. I did a post called Monetizing Cats and Dogs. The part of that post was, or the main thesis that post was, why are we benefiting stockholders? The same amount of people in America own cats and dogs as they do stocks. Why not send cat and dog holders $50,000 checks? That’s the same thing. We’re favoring one group over another. We’ve had equity holders, bondholders benefit from QE for over a decade. Now, it’s time to turn the money hose on the people. One of the reasons I like this idea, first, it’s fair, everyone gets a $20,000 check. Second, it will show how ridiculous this strategy is for the Federal Reserve.
It will immediately create inflation because you’ll suddenly have 7 trillion more dollars competing for the same goods and services in the economy. The sooner that the Fed loses control, the better for free markets and capitalism. I am rooting for the Fed to fail and I know it’s going to be painful, but we need them out. We need them out. When you think about this is their plan, this is the solution. I mean, do you ever just think about that? Free money? Are you serious?
Tobias: It solves a lot of problems it seems.
Eric: We’re printing money to keep things going to pay our bills, to fund these– [crosstalk]
Tobias: It doesn’t make a lot of sense.
Eric: Like they got in a room and they’re like, “Hey, I got an idea. Let’s print $7 trillion.” [laughs]
Tobias: Well, let me play devil’s advocate a little bit.
Eric: “Oh, great idea, Johnson.” Historically, this has always ended very badly. This is what we’re relying on and what investors have definitely relied on to justifying these prices.
Tobias: Well, let me play devil’s advocate for a little bit. We have had this behavior of printing a lot of money. The Fed’s been printing, the government’s been sending out a lot of money as well. It hasn’t really turned up in inflation. Anybody who points to any alternative measure of inflation like ShadowStats, or the Chapwood Index, or anything that gets kind of laughed out of the room, if you’re looking at CPI, which is hedonically adjusted, and there are a lot of adjustments, measurements, probably understating inflation, but who really knows by how much, it doesn’t seem to have had any ill effects. So why not implement that sort of program where you’re sending out money to everybody? Why not just keep on printing?
Eric: Right. Well, and I think the secret is out now that money printing isn’t just for the rich, now you see the stimulus checks and the PPP loans, which aren’t loans, you don’t have to pay them back. They call them loans, I think that sounds better, that someone’s going to pay you back. Most of them will not be paid back. Yeah, you’re right. When it does go to the general population, I think that’s more fair, but then at least, that’s when it will show how ridiculous these policies are. The past 10 years has gone to the wealthy and they’ve done extremely well.
We live in Ponte Vedra Beach, Florida, we live in a modest house, but on my ride to the office, it’s a drive down Ponte Vedra Beach Boulevard, and there are very nice homes being torn down and being replaced with extremely nice homes. I didn’t see that in the last cycle. This is the 1% cycle, where you see this outrageous wealth creation, and it’s being spent. Maybe the guy working on the house that’s being torn down is now making $20 an hour instead of $15, but it’s nowhere near the portfolio of the person owning house whose net worth went from $20 million to $50 million. Obviously, there’s a huge amount of inequality here, and I think now that people have figured out, “If I vote in the right people, they’ll turn the hose on to me. I am going to get it now.” And they are. The last election in Georgia, was people voting for $600 check or a $2,000 check, and what did they vote for? $2000.
Tobias: Makes sense to me.
Eric: Again, the secret is out. I think they’re going to have a hard time now maintaining the hose just towards the rich, I think it’s going to be spread into the economy. Again, when you throw that amount of money into people that are willing to spend it, and they spend it. One of the things we saw in Q2, Q3 was how well a lot of consumer businesses did. It wasn’t like people received their checks and said, “I’m going to save this for a rainy day.” They went to Big Lots, they went to Dick’s, they went to Target, and they spent their checks. Then they had comps that I’ve never seen before. Big Lots had a 30%, same-store sales comp, and then a 70% quarter after, 17%. Dick’s as well. These are comps I’ve never seen but that was, I think, a good example of what happens when you just send checks out. They go spend, and that’s inflationary, or will be.
I went to Target recently to get a TV, a TV in the kid’s room broke. And I got there, and I said, “I just need 50-inch, 55-inch.” They’re like, “Sorry, we’re all sold out.” This was right after the checks were sent out. [laughs] I couldn’t buy a TV. There’s unlimited amount of money, but there’s still a limited amount of production. Toilet paper, it’s a great example. There’s only so much supply.
Tobias: Well, that was one of the things that I thought would happen, and I talked about this a little bit on podcasts, I thought that if you had this supply shock globally, there are still things that are missing even now. We can’t buy everything that we want to buy, and then you print a lot of money, that would seem to me that if you reduce the amount of goods that are out there, and you increase the amount of money that’s out there, the way that you’ve rebalanced that system is that prices go up. But I don’t think we’ve seen that happen really.
Eric: Well, it doesn’t always show up. A lot of these companies calls we read, their inventories are down quite a bit. I know, we have talked about Big Lots, they talk about their inventory, in transit, they’re including the inventory that’s on the boats and coming to them because if you pull that out, it’s an extremely low number. So, the inventory per stores are down a lot. I think you’re seeing two less promotions in the consumer businesses we follow. I don’t know how that shows up in the CPI data, but there’s just not as many BOGOs out there as there used to be. I think it’s showing up. Our AC knocked out and we bought a new AC. It was quite a bit more expensive than it was when we bought our last one 10 years ago. I think it’s out there, how it’s calculated– And we see it with the companies, their costs have risen. With COVID, they did come down to be fair, they did come down. A lot of raw material costs, labor costs, advertising, but those are getting layered back on it. Commodity costs are back up, people are spending again on advertising.
The little quirk is November things started to slow again with the lockdowns. We saw a really a pretty good bounce in Q2, and a sustainable bounce in Q3, and the companies we follow. Q4, it’s more uncertain because of the lockdowns again. So that can be a little pause, and then we had the vaccines, of course, that maybe Q1 improves at some point or Q2. We go back to normal, whatever that was. If normal’s $1 to $2 trillion deficits in an all-time high stock market and 0% rates, not sure if that’s exactly normal, but apparently, we’re going back to that. So yeah, there’s a lot going on right now in the economy and the stocks we follow, and there’s a lot of cross currents. This is what makes it very difficult for us, because, Toby, you remember last podcast we talked about our process a little more, and we normalize things. We try to avoid peak operating results and trough operating results. [crosstalk]
Tobias: How do you normalize this market?
Eric: How do you normalize this market? [laughs] You’re going to be plus or minus a lot. So, you’ve got to do a lot of scenario analysis and try to come up with normal. even tax rates now, what are tax rates going to be? Does the Biden administration know you can just put money, you don’t have to raise taxes? Or maybe he just raises taxes out of spite? I don’t know. But in reality, you don’t have to raise taxes, you don’t have to cut spending, you can just print money. We’ll see. We’ll see whose advisors are and what they advise.
Tobias: I mean, you joke, but that policy prescription is out there. That’s the MMT.
Eric: Sure. For now, it looks like it works.
Tobias: It seems to. Why not?
Eric: I keep saying, let it rip. The sooner we get through this, just send everyone money, see what happens, I think the sooner that the free markets and capitalism return.
Tobias: It’s the problem that while the US is doing a lot of printing, the rest of the world is doing a lot of printing too. It’s a race between the PBOC, the BOJ, the European Central Bank, the Australian Central Bank, every bank in the world is going hell for leather.
Eric: Yeah, in the old days, a country like us, if we printed like we have, the currency would be destroyed. It’s like they found this magic solution, if we all hold hands and print together, we can’t debase relatively. At some point, this is not going to work. [laughs]
Tobias: It doesn’t make any sense, and yet here we are.
Eric: It’s so much more currencies. I had a friend yesterday call me and asked me about bitcoin. I don’t know much about Bitcoin. I’m concerned that there’s so many competing coins out there. I don’t see that limit on supply that a lot of people see. But it’s just people are coming are now aware, “Hey, this sounds too good to be true.” This guy’s a pretty highly educated person, and he’s figured it out. He says, “I need an inflation hedge,” because he sees the money being distributed and being created without effort or sacrifice. We like gold and silver better, Jayme and I do, but the bitcoin might work as well. We just don’t have a strong opinion about it. I think there’s more and more people thinking about what we’re talking about is how can this continue indefinitely? Why not have a hedge in case it can’t?
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Choosing Silver Over Gold
Tobias: Do you hold any precious metals in the fund?
Eric: Yeah. One of our top holdings is silver. We still own the miners, we have one royalty company miner, Osisko Royalties, but the bigger position is our silver position. Silver was at $14 during the crisis or the pandemic and I had owned a lot of miners in 2015. A lot of those had moved. Our thinking was why have the mining risk because miners are very volatile and a lot of things bad can happen, and good. But we just felt more comfortable this time around just owning the actual metal. So yeah, we’ll probably just keep maintaining weight there as we kind of get through this period.
Tobias: I’ve got two questions for you. One is why silver rather than gold because silver as everybody knows this used in industry, so it tends to be a little bit more tied to the business cycle. The second one is, are you doing it physically or are you doing it through an ETF?
Eric: We own the Sprott Physical, silver trust. That’s the physical on that you can actually get it if you want. What’s the first question, Toby?
Tobias: Why silver rather than gold?
Eric: The gold-silver ratio was near 100 when we bought it, so that sort of made more sense to us. One of the thing with miners that we really liked when we own them, and again we still own a royalty company, was the leverage you received, so we could own say a 5% weight in the miner and silver position we have, and probably get a three times kicker on that. Silver for us was sort of a 3X gold, it’s not precise, but that’s the same with the miners, so we’re like, “Alright, let’s get the same sort of response with owning silver [unintelligible [00:44:39] the miners,” because I really liked the idea miners. If you believe gold, silver are going to stay at or decreased from here, a lot of miners make a lot of sense from cash flow. That’s not how we value the miners. We value them on replacement costs, how much would it cost to buy the land, build the mine, and have these develop reserves? That kind of evaluation is always a little stickier, it’s harder to get a higher valuation with those, because those don’t change as much as the cash flows of a minor when gold goes from $900 to $1800, $1900.
Tobias: What’s the significance of the gold-silver ratio being 100?
Eric: Well, historically, it’s been a lot lower. There’s a certain amount of gold in the ground and silver in the ground. The ratio is like 15. Sure, you get more bang for your buck. It doesn’t always revert back, but it’s so extreme when we made that purchase, it just was one more variable that led us to buy silver over gold.
Tobias: Is that the leverage that you’re talking about that you had, the ratio had got so stretched? Or where’s the leverage–? [crosstalk]
Eric: Yeah. If the leverage reverts, and you get the gold kicker, so gold continue to increase, you’d get both. So yes, it’d be a kind of reversion theme. At $14, because– the cost to mine silver at $14, you’re getting pretty close to that, too. That was another factor. I remember that day when we bought silver, and I walked to Jayme office, I go, “What do you think about sil-?” I didn’t finish saying silver, he goes, “Yes.”
[laughter]Eric: We’re both on the same page, and we initiated a position.
Tobias: I’m still not entirely clear. Where does the leverage come from? Is there leverage in the trust?
Eric: Oh, no. Just relative to gold, silver has evolved much more volatile than gold.
Tobias: Oh, I see.
Eric: On the upside and downside, just historically. I call it a 3X, it might be 2, sometimes it might be 4, it moves around, but it has an interesting personality, silver. It moves a lot more than gold, much more volatile.
Tobias: It’s the same with the miners, that you get a little bit– the operating leverage with miners is what creates– they’re more volatile.
Eric: That’s why we were trying to replicate the miners with silver without the mining risk.
Tobias: Got it.
Eric: Yeah, exactly.
Tobias: That’s ideal, right? You make the money without having to pull it out of the ground. That’s the theme of–[crosstalk]
Eric: Yes. Oh. I owned the miners in 2015, and I– oh, man. It was the most painful thing I’ve ever experienced. We bought another miner in March. What was it? Alamos Gold, which I like a lot. It got over the replacement cost, so we sold it. We’ll own them again. It’s wild. It’s not like the owning the market leader of cat litter, or Scotts Miracle-Gro. The fluctuations are incredible. With commodities in general, I never wanted to be a commodity analyst. But really since 2014, the dollar spiked commodities trashed, and value stocks in general were expensive, or small caps in general. That’s where the value was. In 2015, the miners were very cheap, and I looked around saying, “Where’s all my value counterparts?” You can’t own these things professionally. But I did, and I paid the price mentally. They eventually worked out. Then, the same could be said for energy more recent in October before they rallied with the virus– not the virus.
Tobias: The stimulus?
Eric: The vaccine news came out, and then they did very, very well. We had some up 50% to 70% that we own. Before that, no one wanted to own them, you just couldn’t own them. My favorite ideas always come from the question, what sector or what stock would get you fired growing? At $15, it was the miners. For sure. I mean, I can’t tell you how many calls I took and had to explain the rationale for that. “I can’t believe you own these things.” They were so inexpensive. Then, energy in 2020 was the same way. What was the percentage of energy in the S&P 500? It was two and a half percent. It’s interesting. We complain a lot about valuations, but at least in this market, there’s been certain periods where certain sectors have been out of favor, and you can just work and you can stay engaged and find some value and make some money. It’s not all bad, but the ones that are interesting and you can buy, you’ve got to take a tremendous amount of career risk. Not everyone’s willing to do that, but fortunately for us, we’re small and we’ve got Jayme and then Frank Martin, we’re all on board with what we’re doing, so we don’t have to fight internally to buy– actually, I may have fought a little bit with energy. [laughs]
Tobias: That’s how you know it’s a good idea.
Eric: Overall, it’s good. we’re very supportive of our ideas, and we can do that, but for most people, if you bought energy earlier this year when it was extremely cheap, you probably took a lot of heat internally, and that’s really tough, that’s really tough to do to keep your job.
Tobias: I think the difficulty with energy has been that it has looked increasingly cheap over the last few years and as anybody who’s gone in and tried to buy, it has been carted out.
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Opportunities In Energy
Eric: Yeah, I think my first post on energy was in November of 19. I wrote Opportunities in Energy. Then in March a lot of those names got cut. We’re down significantly. I was like, “Nice poster.” [laughs] But then, we were able to buy a lot of those that we’ve been following at even better prices. All of them are really good balance sheets. We own Pacing Systems.
They’re a technology company for energy firms, for rigs, they can measure the depth, the torque, the pressure in the well, the wellbore. This is a really nice stock. We bought it for $5, had $2 in cash. A year later, it was a $20 stock. They make nothing to $1 share. We normalized around 50 cents a share. 10 times normalized free cash flow, paying over 3% dividend, so that was wonderful. Helmerich & Payne is another one, the market leader drill and they have a third of the market share. Pacing, by the way, had 65% market share.
Wonderful, established high-quality energy companies. In HP’s case, it was a point five times book, and normalized cash flows like 200, 250 a share, buying at $14 had a 6% dividend. And no one could buy it, because why? Because the stocks are going down. You just can’t buy stocks that are going down. Natural Gas Services is another one. We have several of these significant discounts on tangible book normalized free cash flow, but they just were so hard to buy, because they literally went down almost every day.
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Small & Micro Outperforms On Every Measure
Tobias: I think that’s what have been the most interesting things that I found in small and micro is that the yields are all kind of incredibly high, given where everything else is. Then on top of that, the growth is pretty good too. I like small and micro, and I’ve got some small and micro. I look at the portfolio, and I think I can’t see how this won’t outperform because on every single measure, it’s better than the S&P 500. It’s better than the indices, it’s better on everything.
Eric: Better than bonds, better than junk bonds, you have better yield in junk bonds. There’s no question. Some of the dividends we’re receiving 2%, 3%, 4%, I agree. And then, you’re going to eventually get the multiple– I don’t know expansion, but you have more of a normalized multiple relative to other stocks. Like Crawford 10 times free cash flow, it makes absolutely no sense if it’s still growing 3% to 4% versus WD-40, which is also growing at 3% to 4%. One is 60 times earnings and one’s at 10%, how does that 60 times ever catch up from earnings or free cash flow yield? You see what I’m saying?
Tobias: Yeah.
Eric: That 1%, 2% coupon, again, really it was so important. You put it on a spreadsheet, how does that free cash flow yield coupon catch up to a 10% free cash flow yield? Either the 10% one has to collapse, but this business has been around since the 60s, so it’s not going away. Or the WD-40 is going to be in our toothpaste, our cereal, our ice-cream, it’s going to have to some way grow 30%, 40% a year coupon to catch up.
Tobias: It’s a very well-managed company. I think they got [unintelligible [00:53:41] after Greenwald wrote that Buffett Beyond Value investing book, and he mentioned that specifically in there. I think that they might have diversified away from the core WD-40 business. He said, if you just pull it back to the core, and then manage this, you’ve managed for return on invested capital, and you bought back stock and so on. They got that message, and then they started doing it, and it’s absolutely exploded over the decades since he wrote it.
Eric: I agree, it’s a great company, the one we want to own. [crosstalk] and great balance sheet too. They have expanded. They now have a WD-40 Regular, and they have a WD-40 for bikes, what the difference is– [laughs]
Tobias: They got a whole product suite there. Eric, we’re coming up on time. If folks want to follow along with what you’re doing or get in touch with you, how do they go about doing that?
Eric: We got our website, palmvalleycapital.com, and our email addresses are on there, and feel free to shoot us an email. I write a blog once a month, and Jayme writes our quarterly letters, and just pretty good content on there. Check us out, read us, and if you like us, give us a call.
Tobias: Eric Cinnamond, fantastic chat as always. Thank you very much.
Eric: Thanks, Toby, really enjoyed it.
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