VALUE: After Hours (S06 E12): Eric Cinnamond On Small Cap Value, Absolute Return, And The Stock Market

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In their latest episode of the VALUE: After Hours Podcast, Tobias Carlisle, Jake Taylor, and Eric Cinnamond discuss:

  • The Power of Absolute Return Investing
  • The Lower Risk, Steady Returns Investment Strategy
  • From Earnings Calls to Investment Ideas: Bottom-Up Stock Picking
  • From Laplace’s Demon to AI Ethics: Biases, Surveillance, and the Limits of Control
  • Can AI Ever Replace Experienced Investors?
  • Investing in a World of Government Intervention
  • Are Stock Market Profits Overinflated? Margin Normalization
  • How WD-40 Became a 50-Year Bond
  • Trillion Dollar Deficits and Rising Interest Expense: Can the Fed Keep Printing?
  • Two-Tire Economy: Middle Class Squeeze Amidst Asset Inflation
  • Reddit Soars 35% Post-IPO: A Case of Meme Stock Mania or Undervalued Gem?
  • Franchise Fatigue: Is Quality Chasing Leading to Excessive Valuation Risk?
  • Beyond Market Leaders: Uncovering Hidden Gems in Niche Industries
  • Russell 2000 P/E: A Flawed Metric? Unpacking the Index Calculation
  • Bubble or Bust? Housing Affordability in a High-Market Economy
  • The Rise of Mega-IPOs: Is There Still Opportunity in Traditional Listings?

You can find out more about the VALUE: After Hours Podcast here – VALUE: After Hours Podcast. You can also listen to the podcast on your favorite podcast platforms here:

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Tobias: This meeting is being livestreamed. This is Value: After Hours. I am Tobias Carlisle, joined by my cohost, Jake Taylor. As always, our special guest today, the inimitable, [Jake laughs] Eric Cinnamond. How are you, sir?

Eric: [laughs]

Jake: Welcome, Eric. Good to have you on.

Eric: Great. Thanks for having me. We talked before this show, and I think we’ve already blown through all the inimitable.


Eric: Welcome to Toby’s B side.

Tobias: So, Eric, just for folks who don’t know, you’re with– It’s your firm or one of three co-founders, Palm– I’m going to say Palm Valley Capital Management. Have I got that right?

Eric: Palm Valley Capital Management. And I co-manage a small cap portfolio. It’s absolute return focused. And the co-manager with me is Jayme Wiggins. Very bright analyst manager. And our other founder is Frank Martin. He’s the Godfather of absolute return investing. He helped finance us and get us started in 2018. So, there’s three of us. There might only be three of us left on this planet that run money this way. So, you’re hanging tight, holding on. And so far, so good, we’re surviving.

Jake: Can you explain, Eric, what the difference is between absolute return approach and a relative return approach?


The Power of Absolute Return Investing

Eric: Yeah. Absolute for us is an attractive return over a full market cycle. We discount our cash flows and our valuations at 10% to 15%. So, when people ask, what does that mean? It means we’re trying to achieve our objective on each equity idea we purchase, which is 10% to 15%. And historically, we’ve done that with our equities.

But what’s very different about this strategy is we can hold cash when valuations are expensive and don’t make sense, and we can’t achieve that absolute return objective on the equities. So, cash could fluctuate from being fully vested to– We’ve been as high as 90% or so. And right now, we’re in one of those periods where we have quite a bit of cash. So relative return investment, of course, is you’re just thinking about the benchmark, trying to keep up, trying not to look too different. You want to beat the benchmark, of course, but you can’t look too different. You might get fired.

So, relative return investing is a little tricky. You can lose 30% and still look good, relatively. And that for us and a lot of our clients, they have no interest in that being down quite a bit. But being a benchmark, doesn’t pay the bills, so to speak. So, yeah, it’s really different. This is how money was run in the old days. You find value, you buy it. When you don’t, you don’t. It’s very commonsense tilt. But yeah, I think all the passive investing right now, the relative return, I think is definitely the majority of how most assets are allocated these days.

Tobias: What’s your bogey? What’s your return bogey for putting something on?

Eric: We use the S&P 600. But you could look at I guess all the small cap benchmarks, the Russell 2000 value, they’re all similar since inception of the strategy. But we don’t spend too much time on it. We’re just required to have a benchmark. But it’s not something we really pay too much attention to.

Tobias: I mean, more in terms of like, what’s the–?

Jake: Internal hurdle.

Tobias: Yeah, what sort of return do you need before you’ll think about putting it on?

Eric: The absolute return?

Tobias: Yeah.

Eric: Yeah, it’s at 10% to 15% annually on the equities. Yeah. Since the fund, with the strategy has been around for a while, but the fund itself was launched in April 19th. We generated seven and a half after fees, which is a little better than the Russell, about the same as the S&P 600. But the equities, because we’ve only been about 20% invested over that time, the equities have returned over 20% annually since inception. So, the equities have done very well. So, we’re really happy about that. We’re happy about being able to keep up with the market without risking that much capital.

So, again, we’ll have our five-year in April. So, we’re hanging in there. We obviously have our position as of last disclosure. We’re not going to be up 20%, 30% this year unless prices get a lot more interesting, anything like that, or even hitting our equity required rates of return on the portfolio that will be tough because of all the cash. So, the cash can bring down our returns over time, but the equity performance can do quite well, because we’re not being forced to be fully invested, we’re not being forced to overpay, and that often for us anyways enhances the equity returns.

Jake: Yeah. It’s fairly astonishing to me, actually, that given this time period that you’ve been operating in and to be beating a fully invested benchmark is– It speaks to the good things that can happen with an opportunistic mindset.


The Lower Risk, Steady Returns Investment Strategy

Eric: Yeah. It takes years. You look at certain periods and we’ll look really stupid. And then there’ll be certain periods where we’ll look very smart. But overall, we just want to look relatively intelligent over a full cycle. But the tracking error is insane, so you have to have the stomach for the relative tracking error or the underperformance. There’ll be certain periods where we underperform by so much that it can make a lot of professional allocators nervous.

So, we don’t tend to get a lot of business from the institutional consultants, because they’re very focused relative. But we do get more business with an advisor that has a private client that may have sold their business and they just can’t afford to lose 30%, because they’re 65 years old and just, they can’t do it again. So, we talked earlier, we’re nice like a sliver strategy, usually not a core strategy where you keep all your assets for a satellite sliver that provides lower correlation to the benchmarks, and hopefully, again, a nice return over a cycle.


Investing in a World of Government Intervention

Tobias: I read through some of your commentary and some of your blog posts. You’ve invested through this whole period, through the late 1990s, early 2000s, most recent period. You said that you felt like the market changed quite dramatically post-2008 when the Fed bailed out Wall Street in its entirety? Can you talk to that a little bit?

Eric: Yeah, before 2008, 2009, quantitative easing just wasn’t a thing. It didn’t– [crosstalk].

Tobias: Other than in Japan. It’s Japanese– [crosstalk]

Eric: It was something taboo. And here we are with the Fed’s balance sheet over $7 trillion. And when we started, Toby talked about this earlier, I think we were at about $800 billion, $900 billion. The rules have changed where the government can come in and buy debt. So, that’s very different. And if you look at really 2008 to now, a large portion of the returns in the stock market are for multiple expansion not necessarily– You haven’t really earned it, you just been given it a subsidy from the Federal Reserve, it’s created tremendous amount of asset inflation.

So, what we do is we normalize cash flows and we use a required rate of return we believe is commensurate with the risk of a business. So, we don’t look at the risk-free rate. So, when rates were at 0%, we weren’t lowering our return objectives. We were trying to stay true to our discipline. There just wasn’t a lot to buy if you didn’t use 0% rates as your guiding light. So, you’re in a period of quantitative easing, you’re in a period of massive fiscal deficits.

We talk about pro forma earnings. If you didn’t have $2 trillion fiscal deficits on a $27 trillion economy, I can guarantee you, if we balance our budget, we would be in a serious recession, if not depression. I’m not saying that’s the earnings you should use, but I don’t think you should be extrapolating these earnings today that are being goosed by Federal spending. The government spending has gone up from $4 trillion to over $6 trillion really over the past four years. I mean, it’s amazing.

So, you had this emergency spending. And COVID, it never really reverted back to where it were. And then you have the deficits and everyone’s like, “Jeez, why are earnings holding up? It’s such a mystery.”


Eric: Government’s flooding the country with money and wealth, perceived wealth anyways. Home prices around here. We live in Ponte Vedra Beach, Florida. Three bedrooms, two bath, I’m embarrassed to tell you what that would probably cost you. It’s just the amount of perceived wealth from the asset inflation, and then you throw on fiscal deficits on top of that. And again, I think it’s why are earnings not rolling over, why are we not having a soft landing? It’s pretty self-evident.

But see, our position is, and why we’re not fully invested is all of this is unsustainable. We’re going to revert to means. We’re not going to have 12% profit margins indefinitely. Historically, it’s more like a 6% to 8% margin. So, we are betting on the cyclicality of human behavior, the cyclicality of the economy, cyclicality of markets, eventually overwhelming all of this artificial interference.

We joked earlier. I might start a pizza shop. Beautiful, right? [Jake laughs] I think we’ll serve some people well, including ourselves. And that’s why we launched. We launched a firm in 2018, launched the fund in 2019, but our whole objective is that absolute return. But it’s also this cycle has just been so insane from so many perspectives that we believe at the end of it, there will be a pot of gold waiting, has to pay off. There has to be a reward for this pain value investors are going through.

When that happens, just like 2008, 2009, it’s so– When the bids disappear and there’s all these values, you’re a kid in a toy store, it’s so much fun. But to do that, you’ve got to enter the store with some liquidity. You can’t be fully invested. You can’t be overpaying for quality, which is extremely expensive right now. You got to look stupid right now. I think that’s probably our strategy is to look maybe as dumb as possible [laughs] when most people are looking geniuses.


Are Stock Market Profits Overinflated? Margin Normalization

Jake: Eric, do you have any sense of–? Let’s say, profit margins, I think, peaked out at 13.3% there for S&P 500. If you were to normalize, let’s take out a trillion-dollar deficit that’s just a sugar high, and take out really low interest rate costs, so interest expense for the S&P 500, where would margins be if we normalized the deus ex machina version of government intervention?

Eric: In aggregate, it’s hard to say, because we look everything bottom up. But I would say from a bottom-up perspective, I would say on average within our opportunity set, I would think margins are probably 40% to 50% higher than they should be. And a lot of that, again, is the government spending, the fiscal stimulus. But also, after COVID, there was a lot of supply chain issues. It was hard for people to find labor.

What a lot of the companies we follow have done is they are making less to make more. Because of COVID, they figured out, “Hey, we don’t have to sell a ton of volume, a ton of price. We don’t have to max out our factories, our facilities, our distribution. We can pull back and just raise our prices.” And it’s cool to lose volume, especially the low profitable things. So, that had a really positive impact on margins. And kudos to a lot of the companies for figuring that out. You don’t have to run at full capacity to make money.

Ralph Lauren is a great example of many things, but one is they just started jacking up the prices over the past– it was just three years, I would think. And margins have done very well. The stocks done well, profits are booming. But they’ve also had the tailwind of the wealthy. Apparel is not doing well right now, but Ralph Lauren is. And that’s because of pricing and the affluent having so much money to buy really nice shirts and slacks. Not like the Amazon essentials I’m wearing right now.


Tobias: You’re a value guy at heart.

Jake: Yeah.


How WD-40 Became a 50-Year Bond

Tobias: You had a discussion about quality in your blog post on WD-40, which a lot of people know because everybody’s got a can of WD-40 everywhere in the world, I think. They’ve done that brand extension where they stick it in everything else as well so you can get your [crosstalk]

Eric: Yeah. I was joking. I said, “How are they going to grow? They’re going to start putting this in toothpaste.” [laughs]

Tobias: Yeah, I think so. I think that’s their plan.

Eric: In the cologne.

Tobias: And it was covered in that green wall book too. It was like that poster child in that green wall book for something that couldn’t really grow, but threw off a lot of cash flow.

Eric: Yeah, it’s a great business, for sure.

Tobias: It was an interesting analysis. You said that for most of its life, it’s been reasonably valued, stayed between 15% to 20%. And then since 2008, the PE has expanded quite a bit with nothing else. There’s no other change really in the business.

Eric: Yeah. And I think the two major factors that we talked about in the blog post where it’s almost a perfect correlation to QE. You monetize debt and PEG rates at 0%. A perpetual bond type business will look really attractive. Now, you don’t demand 8% free cash flow yield with rates at zero. Maybe 3% looks pretty good. And in fact, now it’s a 2% earnings yield with rates at $5, so that’s not making a lot of sense right now. But that’s a whole another topic.

But then you have the passive funds too. The largest holders of the stock are passive funds. And that’s almost also a perfect correlation to the AUM of the passive strategies or the funds that own it versus its multiple. So, yeah, QE and passive has been a very powerful combination for valuation.

Jake: Yeah. That’s an interesting way to think about, like, WD-40’s equity is basically like a 50-year bond. So, of course, that much duration when you change interest rates is going to really move the price of that.

Eric: Yeah. And a lot of the free cash flow is paid out as a dividend, so you’re not really growing internally or you really can’t as long as you’re paying all that out, a lot of that–

Jake: Even more bond like then?

Eric: Yeah. Right. And equity comp too. It was an interesting analogy or example, I guess, of what we’re seeing with the quality. And those are the kind of companies we want to own. But 2%, 3% earnings yield, really closer to two now that just doesn’t make sense, especially where rates are. Not that we use rates entirely, but you’re just like– A few years ago, 0% rates were the reason you would buy, pay 50 times. But now the rates at 5%, you’re still buying at 50 times. [laughs]

Tobias: Yeah. How does that work? How does that work?

Jake: Well, I think it’s like a super inverted curve right now.

Tobias: Inverted.

Jake: Yeah, inverted. Close rates at five, the 10-year at– What is it now? Two or three or something? And then 50 year back at two or something.

Eric: Yeah. But you think about a normalized multiple now for the S&P, let’s just say it’s 33 times or 3% versus 5% or 4%, you have a negative equity risk premium. [laughs] At this stage of the cycle, when I talk– I was a little reluctant to come on. I talked to Jake about this is I feel like I all sound crazy.

Jake: [laughs]

Eric: But when you think about all the crazy things going on right now, the fiscal deficits, political, geopolitical, the profit margins, government spending, I mean, this goes on and on. The threat of quantity of easing– And here’s the crazy one. The Fed is really threatening to cut rates right after they just lost 20% of our purchasing power. It’s like, “Are you serious?” [laughs] This is how you rebuild your credibility while inflation now is starting to pick up? There’s a lot of reasons. Inflation is starting to stabilize and go back up. We can talk about that.

So, you have all these things that are just insane. And then these value investors that preach discipline, patience, maybe now is the time to earn 5% instead of chasing a 2% free cash flow yield. We’re the ones that are crazy. [laughs] You have a negative risk, equity risk premium right now. With all of this going on in the extrapolation of profits, which has never happened before. We never had a linear profit cycle perpetually. It’s never happened. So, you’re betting on something that’s never happened. We’re crazy. [laughs] So, I may be a little bit defensive.


Trillion Dollar Deficits and Rising Interest Expense: Can the Fed Keep Printing?

Tobias: I’ve talked about it a lot on this podcast, but I follow the yield curve. I haven’t talked about it more recently, because it’s gone bananas. But the yield curve, the 10-year, has moved up and down. I don’t know if it floats freely or how it’s priced, but the short end of the curve, the three-month, the two-year, whichever one you prefer, that’s clearly, that’s the Fed pinning it up.

The three month is higher now than it was 12 months ago, which is much, much higher than it was 12 months before that. All of the yield curve un-inversion that happened last year, all of that normalization was the 10-year floating up. And then somebody got the cold spoon out and that fell pretty quickly. It’s been floating around.

The thing that typically ends these yield curve inversions is the Fed getting spooked and pulling down the front end of it. And that just hasn’t happened yet. It’s higher now than it was this time last year when it was already an old inversion. But now, it’s the longest yield curve inversion ever. At its steepest point, it was the steepest yield curve inversion ever. If this doesn’t result in a recession, then you probably got to throw this out as an indicator. But it seems to me that this doesn’t portend good things for the stock market when this finally normalized.

Eric: Well, it’s just like the cyclicality of the economy and profits. It’s hard to throw out those kind of things. They make too much sense. But I would say, I think the Fed did get spooked when the longer-term rates hit 5%. And that was October, November, December. I remember at the time, everyone was like, “Why are they pivoting? What’s going on?” Well, the cost of debt– [crosstalk]

Tobias: Yeah. Fed [crosstalk] government. Is that what you call?

Eric: Yeah. So, fiscal spending on interest expense now as everyone knows is a trillion, well that’s double from just a couple of years ago. So, I think that 5% freaked them out. And now with the threatening to cut rates, I think this is a strategy to help fund the deficits, but also to strongly encourage people to move out on the curve and buy debt, because rates are falling, you better get out and better buy them now, even though we’re issuing $2 trillion in debt. [laughs]. Every year, they’re going fast. Time is lost.

Tobias: This so won’t last forever.

Jake: Yeah.

Eric: Don’t make me cut four times. [laughs]


Two-Tire Economy: Middle Class Squeeze Amidst Asset Inflation

Jake: It is hard to imagine a scenario that’s barring just some absolute incredible Hail Mary technology advancement that lands. Maybe AI is that. I don’t know. Robots and whatever. But where there’s not just continuous ingredients for inflation to be persistent for quite a while.

Eric: I mentioned earlier, some of the things that are reversing that we’re seeing with our companies from the bottom up. There was a tremendous amount of inventory destocking last year. And that’s run its course. So, you’re not going to need the amount of promotions and inventory. You have to dump your inventory. And what that also did when people are reducing their inventories, also they’re doing that to generate cash, which was very effective. But they reduced freight.

Trucking prices collapsed, because everyone was destocking every inventory. That’s over. There’s a lot of excess capacity coming out of the trucking industry right now, because these rates don’t make sense. And of course, you have gas prices going back up. So, that was a huge tailwind for a lot of companies and for inflation on the goods inflation. So, that is going to go away second half of this year.

And obviously, you had very easy comparisons against year over year inflation. The Fed’s getting a lot of credit for reducing inflation. But in reality, it’s because they did such a poor job over from 2022, 2023, that now inflation comparably looks, “Oh, great job.” It’s like my kids getting an F and then they get a D, and they say, “Wow, the D is a lot better than F.”


Tobias: That’s called inflation.

Eric: [crosstalk] inflation. Yeah. The next year makes it a lot easier. If you do really bad with inflation, which they’ve done, they destroy 20% of our purchasing power. Now all of a sudden, this is good. 4% inflation, that’s nice. But let’s, again, not forget that go try to buy a house right now. Pay your auto insurance bill.

There are so many things in our life anyways, that when I pay the bills, it’s like, instinct now in my head, I just have this inflation head shake. I’m like, “Oh, my gosh.” And then I say, “Are you going to Panera Bread and buy a sandwich with your kid, and you leave and you feel like you need to take a home equity and loan it out?”


Eric: So, they can celebrate this inflation victory all they want. The reality is the middle class and the lower class have been absolutely destroyed. They’re under a tremendous amount of pressure.

I’ve got one example and I’ll stop, because I know I’m talking too much. But we have a company, Monroe. They do auto repair. They came out with their earnings– On their last earnings call, they’re talking about customers instead of buying four tires, they’re buying two tires. And the customers that were historically have been buying two tires are now buying one tire.

Jake: Jeez.

Eric: So, you have this large percentage of the population that is debating whether to replace two tires or one tire. And that’s probably half the population that hasn’t participated in this massive asset inflation. We have this so-called balanced economy. In reality, what it is is half the economy is booming, people are just crushing it. Money is coming out of their ears, and the other half are just been devastated by all this inflation. And for us to start cutting rates now, while asset prices are record highs, home prices are record highs. And to somehow justify this and say [chuckles] we’re going to have a soft landing, you’re just going to keep empowering the rich and keep hurting the poor.

So, I think we’re in a moment where asset inflation is not the answer. But that’s where we’re going. We could have a melt up here. We don’t know. You’re cutting rates and threatening to slow down QT in an environment that feels almost like 1999. [laughs] To me, again, it goes back to, “I’m crazy.”


Eric: This environment is just nuts.


Reddit Soars 35% Post-IPO: A Case of Meme Stock Mania or Undervalued Gem?

Tobias: Speaking of 1999, I don’t know if you guys follow this closely, but Reddit– Do you guys know what Reddit is? Reddit, the website, has gone public? Ticker’s RDDT. Its stock is up 35% since it listed and it came out– It was rich when it went out. I didn’t do a DCF on it, because the bottom line is a negative number, which I find– It’s hard for me to imagine how that is the case, because they have this website where they just have all of these people who contribute to it for free. So, if their cost of creating the product is virtually nil and somehow it doesn’t make money. But in any case, it’s up 35%. That’s perfect for this environment.

Eric: I take it’s no longer small cap.

Jake: [laughs]

Tobias: It’s $11.5 billion. What’s your definition of small cap? I think it came out at 2008. You probably could have snuck it in there.

Eric: Yeah. So, we actually have a very wide definition, $100 million to $10 billion. So, we want to keep as many opportunities as possible. So, we’ll have to get that symbol from you again.

Tobias: You have to take your analyst and slap him around a little bit, because it came out at 2008 and it would have exited at 2010, it would have been perfect. You could have just had that little 25% trade there.

Jake: [laughs]

Eric: Well, back in the old days, when I worked in New York– I was in my mid 20s and I would go to these road shows. I was always volunteer, because IPO launches in New York were just like five stars. Incredible. And I was this broke 25-year-old kid, and I would sit in this table with management and I would be eating. All I’d be focused on is the food. It is like, “I can’t believe this. This is unbelievable.”

Jake: Just eating shrimp. [laughs]

Eric: But then I would go back and tell the portfolio manager, “Yeah, buy some.” Because it always went up. The IPOs always go up. You get allocated a certain amount of shares, and then they would sell them the next day to flip them, make a profit. But the IPOs, man, if you’re analyst on the buy side or sell side and you get to go to one of those lunch or dinners, strongly recommend that.

Tobias: You don’t want to hold it for too long. I checked out all those IPOs from a few days ago. They’re all down a touch.

Eric: Yeah. You want to definitely flip it. You don’t want to hold those.

Tobias: Those are trading sardines.

Eric: Take your lunch and your 30%.


Tobias Carlisle: It’s late, but let me give a quick shoutout before.

Jake: Oh, yeah.

Tobias: Sorry, JT, just before I cut you off.

Jake: Yeah, go ahead.

Tobias: Toronto. Teslaville, what’s up? Speaking of which down a little bit. Nashville. Valparaiso, what’s up? Port Arthur, Texas. Perth, WA, 01:32 AM. That’s strong. Durham. Jupiter. Congrats. New Delhi. Snohomish County? Salem. Cromwell, New Zealand. Good to have you. Old ocean, Texas. Brandon, Mississippi. Istanbul, Turkey. Lausanne, Switzerland, winning. [unintelligible [00:27:24] Mendocino. Helsinki. Hong Kong.

Jake: My God. It’s worldwide.

Tobias: Belgium. Las Vegas in the house. Sorry, JT, [crosstalk].


From Earnings Calls to Investment Ideas: Bottom-Up Stock Picking

Jake: I was just going to say that some of my favorite work that Eric does is bottom up– He’s one of the best bottom-up economists. So, looking at the companies, reading all their transcripts and earnings calls, and actually ferreting out like what is happening from the bottom upwards, rather than all the economists tend to be more top down, it feels like. But Eric, maybe you could share some of the interesting findings that you’ve been noticing lately on the last update that.

Eric: Yeah. The reason we do that– I’m glad you brought that up, because that is something, I think it’s a little different. A lot of bottom-up analyst and managers, they don’t have a macro view. But because we normalize earnings in our valuations, it’s very important for us to understand where we are on the profit cycle, whether you’re peak or trough.

In 2009, you’re in the trough, you don’t want to use those earnings to buy a company because they’re too low. And then I would argue currently margins are so high, you probably don’t want to use these margins either to buy a company. So, what we do is– We have a possible buy list of about 300 names. And every quarter, we read the releases and conference calls and come up with our macro view.

And it’s a couple of pages, kind of a summary of our highlights, and it’s a little over 100 pages of notes. But it’s interesting, because I think one of the things we picked up on pretty quickly in 2021 was inflation, because we were seeing it with all of our companies, but we weren’t seeing it yet in the government data. So, there’s things like that I think we can pick up on. In fact, I wrote a blog post called Buy Things. And my whole theory was the companies are clearly communicating price increases. Go out, buy some appliances.

Jake: [laughs] Yeah, get out and find that.

Eric: I bought like three years’ worth of weeding feed and I think I made like 30% on that.

Jake: [laughs]

Eric: So, you could see a lot of things through the bottom up that you can’t really see in government data, which is often seasonally adjusted, massaged. Usually, it’s revised and it’s dated. So, things we’re seeing right now– We touched on the two economies, economy one, economy two, one doing great, one doing awful. I would think that’s the biggest theme right now of the disparity so large.

And then going to the fiscal side, a lot of cyclical companies tied to the economy, manufacturing, construction actually doing quite well. You have a lot of spending on whether it’s data centers, semiconductor plants, infrastructure across the board, roads and bridges. We had an asphalt company. Gencor Industries, we owned for a while. Did very well, but that was just the government flooding the system with money to pave roads. So, that’s done well.

Transportation has been weak, but I think that’s going to change. I think that’s going to pick up. Energy has been pretty good. Natural gas has been awful, but oil has done so well for these companies. There’s quite a bit higher than cost and they’re doing well. Services, energy service has lagged the EMPs just because EMPs have had so much more pricing discipline this cycle.


Franchise Fatigue: Is Quality Chasing Leading to Excessive Valuation Risk?

Eric: Another theme that is very important that we’re seeing is small cap companies with debt. The maturity walls are getting really– they’re getting a little uncomfortable. [Jake laughs] Some of these smaller cap companies, they’re not like McDonald’s, which has a lot of debt, but they can still go out and issue debt and there’s no issue. But these smaller companies with debt, with maturity while approaching, if you even bring up like, “Hey, I might need capital,” the stock’s going to get destroyed.

I don’t think markets are particularly efficient right now, but one thing I think they have done a good job with is smaller cap companies with debt, when maturity walls approaching, those stocks are down. So, if you’re going to take risk right now, and you know the company really well and you think they’ll survive the next recession or credit crunch, I think financial risk is probably where I would look. Fortunately, we don’t have to fully invest, so we don’t have to buy a highly levered company to try to stay invested. But that’s interesting right now what we’re seeing it from the bottom up.

Tobias: I had a look at the Yardeni site where he splits out the PE. It’s a great website if anybody’s looking for a whole lot of charts to stick into stuff. But he splits out the PE multiples of large cap, mid cap and small cap. And one thing that really stood out to me is that large cap PE multiples have mostly expanded. But mid cap and small cap have definitely been contracting. I just wondered if that was a reason that you’re identifying that the small and mid-cap have a lot more trouble rolling their debt.

Eric: Yes, the market has done a better job of small caps, because you don’t have the flows. You get the S&P and the QQQs. Especially like foreign investors, you are usually not buying the small caps or just piling money into the larger mega caps. But still, I’m not saying small caps are cheap, but I would say in certain areas, I think the market’s done a little better job of penalizing companies that may have taken on too much debt through buybacks or acquisitions, and they’re not giving them a second chance. And if you ask for debt, your stock is going to get killed. So, I do think that’s true.

But the makeup of small caps is a little different too. There’s the money losing companies, which haven’t done well at all. The S&P, for the most part, is profitable companies. Mainly the larger caps in general are usually companies that make money. But small caps are 40% money losers. So, the market’s probably done a better job of beating those up. If you look at just profitable small caps and maybe mid caps, I don’t know, it’s a little different picture where the valuations are quite a bit higher than they were.

I did a post that said this is not 1999. In 1999, not from a small cap perspective, maybe it’s looking a lot like 1999 from a large cap technology perspective. But in 1999, you could buy WD-40, probably in the mid to low teens multiple, but now it’s 50 times. But there was a plethora of high-quality small caps. You could buy 15, 10 times earnings. Dirt cheap. But now those same companies are twice, three times the valuation. So, quality has done very well in small caps, and that goes back to profitable companies. And quality have done a lot of well done very well.

I think the reason for that is when things are expensive, a lot of professional investors especially, they need to participate, so they don’t lose assets. And I think they feel if I buy quality, maybe I’m kind of cheating, but not really. At least I’m buying some good stuff. I remember this manager that used to just say in his presentations, he would just go, “Franchise.” That is like [Jake laughs] forgiven.

Tobias: Plastics.

Eric: It doesn’t matter what you pay. As long as you said franchise, it’s all good. [laughs]

Tobias: [crosstalk]

Eric: So, I think a lot of people are chasing franchise businesses now, feeling safe from the business perspective. But in reality, I think they’re taking a tremendous amount of valuation risk which, of course, the price you pay is usually the biggest determinant of how you do.

Jake: Yeah, there’s a pretty common refrain of you want to own quality into a recession. But if everybody arrives at that conclusion, it gets priced in. And now, is that actually smart to do maybe a little bit more of a question mark.

Eric: Mm-hmm. Yeah. And you don’t want to buy highly levered cyclical companies into a recession. But I think in small caps anyways, they’ve sniffed that out already. And maybe if you had to be invested now, maybe that is. Maybe you do want to buy a cyclical. You want to take operating risk or financial risk going into a recession, which is weird or different. But just where prices are, maybe that does make more sense.


Beyond Market Leaders: Uncovering Hidden Gems in Niche Industries

Tobias: Do you find any industries or sectors interesting? Are you allowed to name names, or do you know names?

Eric: The things we’ve been buying and own or have owned, we have been selling some into this market melt up over the last few months. But they’ve been very smaller industries that you just don’t think of. We talked about Gencor, the asphalt plant equipment. They own 40% of the market share in asphalt plants. So, they’re the market leader. But it’s like a $250 million market cap. [chuckles] And then we own the market leader in tow trucks. We own an insurance adjuster, we own a company in Canada that made fruit snacks and juice.

Some of these are not big industries or ones you really classified, excluding the food company. They’re just unique industries, smaller that even if they own 100% of the market, they would never be a mid-cap stock.

Tobias: One of the things that stood out to me from that Yardeni chart that I mentioned a little while ago was that for most of the last– I forget how far it goes back, but it’s at least 20 years, something like that. For most of the last 20 years, mid cap and small cap have traded at a premium, a PE multiple premium, to large cap. And it’s only since the pandemic that the large caps PE multiple has expanded beyond. I don’t know if that’s ordinarily the case or not. I just can’t remember. But it just seemed odd to me that since the pandemic, it’s flipped in any case, and I don’t know.

I guess the argument could be that, before then, you want the faster growing stuff. Mid cap, small cap grows faster, so therefore, the PE should be higher. Post pandemic, large caps are safer financially, so therefore, you pay a higher price for that. Given you a small cap guy, do you have any view on either of those thoughts?

Eric: Well, it’s tough to use small cap valuations in aggregate, because there’s so many things that affect the multiple. We talked about money losing companies about 40%. And then like the Russell 2000 value, huge portion of that is financials. And you look at those multiples, they’re very low. And I don’t think they’re the real multiples. I don’t think those are the real earnings. If you mark to market, for instance, the commercial real estate loans or any of the longer data loans, the ones that are not using margin– [crosstalk]

Tobias: Health maturity.

Jake: Yeah.

Eric: Yes. So, that actually skews the small cap multiple down considerably. There’s a tremendous amount of small cap banks that might be insolvent right now if you use mark to market. So, you got to be careful with that.

And energy too right now, a lot of multiples are low because of where oil prices are. We get that a lot, because some of the multiples look reasonable. If you pull everything out, you pull out the money losers and leave in the banks and leave in some of these cyclicals that are doing well. But if you normalize on a bottom-up basis, the picture looks very different. So, we always want to caution people to be careful with these aggregate multiples. Sometimes people will give you multiples like fact sheets and whatnot, and they won’t even explain how they derived it, because if you exclude a lot of things, you can make any benchmark look interesting or portfolio.


Russell 2000 P/E: A Flawed Metric? Unpacking the Index Calculation

Tobias: I always thought it was funny how the Russell does that calculation. They exclude all of the things that are non-earnest and then they truncate the really high PEs. So, the PE, it’s a bizarre calculation.

Eric: That’s right. Yeah. Jayme’s done a lot of work on that, because we get asked a lot by clients if multiples are here. Someone told us long caps are 14 times earnings on a normalized basis. We’re not seeing anywhere near that. We would recommend being careful on aggregate valuations.

Tobias: How do you normal–? [crosstalk] Sorry, JT.

Jake: I was just going to answer the question about that inversion of multiple between small and large. The charitable version would be, in my mind, returns on scale and technology companies, like making tons of money and that whole thesis playing out and maybe some truth to it. My less charitable grinchy version would be like, probably the bigger the company, the closer you are to the trough of money pouring out, Cantillon effects of– And you get the money before it trickles down to a smaller company. So, your margins look better. You get the revenue before the cost inflation shows up as much. So, of course, then you look more profitable.

Eric: I would say too. I think those are good points. The equity comp for larger companies is quite a bit larger than many of the companies we follow. And then that often gets excluded from earnings. So, again, there’s a lot of–

Tobias: The SBC.

Jake: Oh, yeah.

Eric: -a lot of exclusions out there, [crosstalk]

Jake: Microsoft, $11 billion a year, I saw, on a quarterly run rate basis.

Tobias: Yeah, [crosstalk]

Eric: We should be trying to get a job at Microsoft.


Eric: What are we doing?

Jake: Right.

Eric: That doesn’t show up in earnings, but it shows up in cash flow when you buy back the stock. I know you guys know that.

Jake: Yeah. And some of those tech companies, the SBC as a percentage of free cash flow is extreme. 20 is like considered a gold standard, and there’s lots of companies that are north of 100%.

Eric: Yeah. And that goes back to multiples. Most analysts will just– They go past all of the things that are said to be one time that occur almost every time, and then they go right to the adjusted earnings, and they slap a multiple on that and they go to lunch. [laughs]

Jake: 2027 adjusted earnings.

Eric: Yeah. The [crosstalk] rule


Bubble or Bust? Housing Affordability in a High-Market Economy

Tobias: How does this all play out, Eric? We’ve got an election this year, which is presumably why there’s so much fiscal stimulus around. I think the Fed to some extent has been counteracting that, although they seem like– as you say, they’re threatening to drop rates all the time, which seems to have helped keep everything elevated. Six rate cuts this year. Now we’re through a few of the meetings, so now it’s three rate cuts this year or something like that. But what do you think? How does this play out?

Eric: That’s why I came on, Toby. I thought you were going to tell me.

Tobias: [laughs]

Jake: Yeah. [laughs]

Tobias: I don’t know. I’ve given up. I think I just say the market is going to go down 50% at some point in the future, [Eric laughs] at which point returns will be really good. But that’s my evergreen prediction. That’s always true.

Eric: I’m going to go with that. What you said sounds great.

Tobias: [laughs]

Jake: I did see that. There was a guy who changed his legal name to-

Tobias: Oh, yeah.

Jake: -Anybody Else. [Tobias laughs] That’s his name.

Tobias: Literally Anyone Else.

Eric: [laughs]

Jake: And he’s running for president.

Tobias: He’s going to win. [crosstalk] he’s going to win.

Eric: If he wins. [laughs]

Jake: What if we had a new third party that became just from the votes of Literally Anybody Else? [laughs]

Tobias: The funny thing about that guy is, he’s 35 years in like one week or something. Like, he waited until run. This is the very first time he can run.

Eric: I tell you though, one thing about where we are right now is I’m baffled by this– We have to cut rates right here. It doesn’t make sense. So, it does make you wonder if it is political. And if it is political, does this backfire? Because if it’s political and it tilts for the democrats, well, half of the population doesn’t own stocks. A lot of their voters don’t own homes. And now you’re going to put them further behind the wealthy. Maybe they’re going to be upset by this.

Tobias: The way that backfires is Bastille–

Jake: Yeah.

Eric: Do you think they care when the QQQ goes up a percent every day?

Tobias: Bastille Day.

Eric: Yeah, I think this could backfire on them, if it is political.

Tobias: Everybody gets a shave.

Eric: There’s so many things that could happen that cause this cycle to end. But one that doesn’t get a lot of talk is the social or the wealth inequality. When we just pay our bills and things, I just wonder, “How in the world can people afford to live right now?” Just making that worse, to me, it’s not only not the solution, which is the way they’re going. I think it’s just going to build a bigger and bigger issue down the road. Of all things not sustainable, having half the population do very well and really just crushing the other half, it just doesn’t seem sustainable to me. But it has been going on for probably longer than I expected. So, [crosstalk] that.

Tobias: Well, unemployment close to all-time lows, stock markets at all-time highs, real estate markets, very expensive.

Eric: Housing affordability, right? Our first house, I think was $250,000, and I thought we were overpaying. [laughs]

Tobias: You can never overpay in real estate.

Eric: Not in Florida– [crosstalk]

Tobias: And this is 2006.

Eric: Yeah. Well, that actually was 2004. And then our house went up to $400,000. I couldn’t believe it. We sold, and then we rented for two years, waited for the bust and then we bought. So, we actually day traded the home two years. So, that worked out really well. And then I’m like, “Well, do we do it now?” Because now our house is worth a stupid amount, again, for no reason except asset inflation. But the difference today is, we have kids now, so it makes it a lot harder. But the cost to rent is significantly higher. So, that renting equation doesn’t work as well or that variable. And I feel this cycle, I want to have part of our cost-of-living locked in. Like, I don’t trust the Fed.

in 2006, 2007, or 2006 when we sold, QE wasn’t a thing. I think if you sell and rent now, you’re taking more risk in that. The next recession or crisis, they print another $5 trillion. And now you’re in an apartment with kids and your wife and they’re like, “What’s up?” [laughs]

Jake: Yeah. I thought were going to be in a mansion by now.

Eric: Yeah, “You’re priced out. I wish we were in our house.” So, it’s a lot trickier. It’s tempting, for sure, to take those games. But everything is so expensive now. The arbitrage is a lot different now than it was in 2005, 2006. In 2006, you could sell your house, and rent, and take the proceeds, and put it in a 5% CD and it almost paid for your rent. It was wonderful. You can’t do that now, because rents are so high.


From Laplace’s Demon to AI Ethics: Biases, Surveillance, and the Limits of Control

Jake: Shall we get some veggies-

Tobias: You can say veggies.

Jake: -under the wire before it’s too late?

Tobias: Yeah, let’s do veggies.

Jake: Yeah. I try when I’m at my best to match up the veggies along with the guest. And as I mentioned before that Eric is to me one of the great bottom-up economists out there, coming through all these earnings transcripts and then offering these real time insights that happen before, they show up in official statistics. But it got me thinking about this other fellow who made predictions about what it would be like if we could measure everything.

And his name was Pierre Simon Laplace. and he was a French scholar and polymath, and he lived from 1749 to 1827. And he made important contributions to engineering, mathematics, statistics, physics, astronomy. He has his name on a few equations, which is always about as big as it gets, if you can get your name on something. One of them is in the field of partial differential equations. Don’t ask me to tell you what that is. But apparently, they use it for describing tidal flows. He was also the first to predict the existence of black holes. In 1814, he set out a mathematical system of inductive reasoning that’s based on probability, which today we would probably recognize as Bayesian statistics.

So, anyway, today, we’re going to be discussing this thought experiment that he had called Laplace’s demon. And it’s an exercise in causal determination. It goes as follows. Imagine that there’s a demon which knows the precise location and momentum of every atom in the universe, and their past and future values for any given time. It could then be calculated and predicted with perfect accuracy. By the way, Laplace never used the term demon in any of his writing. It was just added later for embellishment by others. But what if you could measure every single little absolute detail, and then could you accurately predict a future at that point? And this is, I think, an interesting thing to think about AI then. And as we’re trying to measure everything using AI, can AI do predictions that are better than–? Can it measure every little atom in the universe effectively?

Now, there are four arguments against Laplace’s demon in the physics realm. Number one is entropy. Laplace’s demon was basically vanquished with the discovery of irreversibility and entropy, the second law of thermodynamics. It’s based on the premise that there is reversibility. But many thermodynamic processes are irreversible. So, imagine like, you stir a cup of coffee with cream in it, you can’t get the cream to be unstirred ever at that point. There’s also the problem of quantum indeterminacy. This is basically like Heisenberg’s uncertainty principle. There’s properties like position and momentum, which you can’t know both at the same time. And then there’s chaos theory and the sensitivity to initial starting conditions. So, this is like the classic butterfly effect, where small changes produce these huge inaccuracies and predictions. This one’s a little bit less convincing, because the premise of Laplace’s demon is that you know every initial condition with perfect accuracy.

And then the last one is computational complexity. There was recently some work that had a proposed limit on the computational power of the universe. The limit is based on the maximum entropy of the universe using the speed of light, the minimum amount of time taken for information to move across the Planck length. And it’s been shown to be about 10 to 120 power bits. So, basically, it would require so much computational power to ever figure this out that the amount of time that’s eclipsed since the universe started is not enough to ever really do it.

But let’s think a little bit about Laplace’s demon and AI, because it’s an interesting topic right now. AI has the same problems of trying to predict outcomes based on data, like, what is known today, what is going to happen tomorrow? And in this context, it’s a useful metaphor. The AI is trying to predict future events. And if it had complete information, maybe it could, but it’s never going to have– There’s always fundamental limits to how much information you can actually have. And AI faces that same type of constraint. There’s also the quality and the quantity of data that the AI is trained on. So, in that way, that mirrors the impossibility of Laplace’s demon having complete knowledge.

And then there’s some ethical considerations, actually, just like Laplace’s demon raises questions about really, like, free will around judicial sentencing, loan approvals, recruitment. If you’re using AI for some of these things, there are these biases that can be baked into the AI based on the training data. And if an AI is that good at predicting individual human behavior, what does that imply then it is personal responsibility and free will?

And then the last one is kind of omniscience and control. The idea that if an entity could predict every future event, what kind of surveillance then would be required? Like, you almost start to run into minority report, the sci-fi movie with Tom Cruise predicting murders and things like that. So, what does that mean then for privacy, and autonomy and control of governments? So, hopefully, there’s a little bit of maybe thinking through some of Laplace’s demons and the implications of that from a physics context that we can then apply to AI to help us give us some kind of metaphorical framework to explore the capabilities and limitations of AI.

Tobias: What about natural intelligence? Does that suffer from those same limitations?

Jake: Yes, of course.

Tobias: More inconsistent.

Jake: True.

Eric: On the ethical side, this is timely. My daughter’s English class had an essay assignment, and they discovered half of the students used AI to write it.

Tobias: How did they discover?

Eric: And the teachers now are using AI to find AI.

Tobias: Ah.

Eric: And so, this is going to be an issue for the academic world, because half the class decided it was a lot easier [chuckles] to have AI write their essay and the other half did it. So, that’s just one example. But there’s going to be a lot of ethical issues.

Tobias: How do we pivot back to investing, JT? You’ll learn to plan.


Can AI Ever Replace Experienced Investors?

Jake: [laughs] Ah, ooh, boy. Eric, how well do you think a model could do if you gave it all of the data that you collect on a bottom-up basis from these individual companies? Do you think that there’s more insights to be gleaned from there, or would it start tipping into absurdities?

Eric: I have trouble thinking a computer can accurately predict the cyclicality of these businesses. There’s so many variables that can affect margins, and they all move different ways at different times. A lot of it’s based on human behavior. So, I’m too reluctant to feel confident of evaluation spit out by an AI model. In the data going in, is that accurate? Is it smooth? We talked about the multiples being not really accurate in some cases. So, when you look at an operating margin of a business every quarter, there’s just so many things that can make it go one way or the other that are– I don’t know, maybe we do need AI, because my mind is having a hard time comprehending this.


Tobias: Do you find it helpful for hunting for ideas to look through–? Is that why you do it to look through industries and look through them at that level–? You’re looking for something that might be depressed but showing signs of life?

Jake: Or, is it to help normalize for the companies that you’re modeling?

Eric: Yeah, it’s more for normalized. But we follow a lot of the same companies that we followed 20 years ago. So, there’s only so many mature market leaders in small caps, and that hasn’t changed over many years. I hate using it. I always use this, but I’m using it anyways. Oil drives the market leader in Cat Litter, one of the market leaders, and it was founded in the 1960s. I’m very confident it will be one of the market leaders in 10 years from now. I’m very confident many of the variables that drive the earnings will be similar.

So, for us, a lot of it too is familiarity. We have 300 names. We know them well. So, we follow the same ones. And some get bought out, and a name will come on the list and they will come off. But over time, just following the same things, knowing something really well, I think provides a really good advantage. Because when COVID hit and small caps fell 40%, we didn’t have to do screens. It was immediate. We had ideas, we were buying immediately. And because we had familiarity with the names, we knew it was affecting margins and we had a good idea what normalized were. So, yeah, I don’t know if AI could recreate that. If it could, I guess we’re done. [laughs]

Jake: Well, or maybe AI would allow you to keep a larger inventory of ideas on the shelf then.

Eric: Yeah. Or, it could alert you to, “Hey, this is trading below normalized. The profits are above normalized, profits are below.” And it could maybe help you with your screening, where should I look? I think it might be more useful that way for us over time. But that’s going to be tough for us to transit, or at least for me, because how I’ve done things for 30 years, I admit that would be hard.


The Rise of Mega-IPOs: Is There Still Opportunity in Traditional Listings?

Tobias: Criticisms of the small cap indexes has been that there’s a deterioration in the quality of small caps, because for a variety of reasons. One, it’s more costly to be listed. So, some companies just stay private equity, get handed back and forth between private equity. And other companies like Facebook, they wait until they’re huge before they come on the boards. Maybe even Reddit. Like, it comes on at $8 billion, where previously they might have listed as smaller companies and worked their way through those indexes and graduated into mid cap or large cap indexes. Is that your experience or something else?

Eric: Yeah, I’ve been doing this since 1993 and I definitely think the quality has declined. You could see that with the percentage of companies that lose money. But that’s somewhat cyclical. Here we are in a booming profit environment and you still have 40% of companies losing money. [chuckles]

Tobias: Is that because they’ve never made money? They raise capital and they burn it?

Eric: Yeah. The last IPO boom we had, a lot of them were SPACed, right?

Tobias: Yeah. SPACs are back.

Eric: They weren’t making or losing money, they just were given money. [laughs] So, that was odd. But we usually don’t buy a lot of IPOs, because we buy more mature businesses that have been around a long time where you have a long operating history. But some of these IPOs do– But by now, if you’re a market leader, mature business, you’ve probably already gotten bought out. There’s not a lot left ready to go, “That kind of business that are ready to go public.” Like you said, there’s a lot of reason now probably it’s not worth it, especially if you don’t need capital. And if you need capital, that’s usually not the type of company we’re interested in.


Tobias: Eric, we’re coming up on time. If folks want to follow along with what you’re doing and get in touch, how do they do that?

Eric: is our website. And we have a blog and recorder. Jayme writes her letters which are very good. Come to our website. And if you like our content, that’s awesome. And if not, we understand. A little different. But we appreciate your interest in your time, guys. Jake and Toby, really appreciate you having me on.

Jake: I’ll put in a plug that Eric’s blog is one of the very few blogs that I read regularly. Pretty much anytime he puts something, I’ll read it within 20 minutes. [laughs]

Eric: Jake, that’s because it’s under 1000 words, right?

Tobias: Yeah. That’s not a bad thing.

Jake: Doesn’t hurt. Yeah. [laughs]

Tobias: Eric Cinnamond, thank you very much, folks. We’ll be back next week. Same bat channel, same bat time. See you then.

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