18 September 2017

One of the most lucrative and highest yielding areas of investing is finding quality companies in the small cap market.  The difficulty with investing in this space is the companies often lack stability and market dominance to make some investors comfortable.  On this episode, we talk to a leading expert and former hedge fund manager that has invested in the small business space over three decades.  Eric Cinnamond currently runs his own blog where he provides a detailed analysis of all the conference calls and small cap companies he follows (a couple hundred businesses).

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  • Why small cap investing can be profitable for the right type of investor.
  • Why you should always question where you are in the profit margin cycle.
  • Why money managers are 100% invested in a market 80% of them believes are overvalued.
  • Why cyclical stocks are hated and yet can be extremely profitable.
  • Ask the investors: How do I value stocks with declining net income?


Disclaimer: The transcript that follows has been generated using artificial intelligence. We strive to be as accurate as possible, but minor errors and slightly off timestamps may be present due to platform differences.

Preston Pysh  0:02  

Hey everyone, so Stig and I are so pumped to share today’s episode with you because it was quite a learning experience for the both of us. Our good friend and former billion dollar hedge fund manager, Jesse Felder told us about today’s guests, and he insisted that it was an important person for us to interview. 

So Jesse told us that we would be hard-pressed to find a guest that knew more about small cap investing. And boy, was he right. So, after hearing this interview, you’ll quickly learn why Eric Cinnamond, who’s today’s guests came with such a strong recommendation.

Stig Brodersen  0:34  

When we originally invited Eric to come on the show, it was to talk about small cap investing, where he’s really the top authority. I learned a lot from our discussion about how prices were set in the small cap market compared to large cap stocks. What really surprised me was whenever we transition into our discussion about profit margin cycles. What most investors do is that they look at the past 10 years and then they make some assumptions about the free cash flows and the earnings of that stock. However, what you might be looking at is two positive credit market cycles and one negative or the opposite. 

Together with Eric, we want to solve that in this episode.

Intro  1:14  

You are listening to The Investor’s Podcast while we study the financial markets and read the books that influence self-made billionaires the most. We keep you informed and prepared for the unexpected.

Preston Pysh  1:34  

So Eric, thank you so much for coming on our show. It’s such an honor to have you here. I know our audience is really going to eat up this discussion about small cap investing.

Eric Cinnamond  1:42  

Thanks a lot, Preston. And thanks, Stig for having me. And, of course, thank you, Jesse for recommending me. I appreciate that.

Preston Pysh  1:49  

So whenever I look at your background, I see that you’ve actively managed money for 18 years. And recently in 2016, you returned the money from your fund back to your investors. And in your bio, you talk about this idea of relative returns versus absolute returns. Talk to our audience about, first of all, why you return the money. And second of all, this idea of relative versus absolute returns.

Eric Cinnamond  2:17  

Yeah, that’s a great question. First, why return the money? Absolute return investing, if you’re not getting paid to take risk, I don’t do that. But actual return investment for me, actually I have a specific hurdle rate, and that’s 10% to 15% on my equities. And if I can achieve that, that’s my objective. [Money] to achieve that at whole cash. Well, what happened to me in 2016, is I had a high level of cash at that time, at about 80% cash, and I was also in a very contrary position, the precious metal miners. 

I mean, imagine that holding 10% to 15% miners, and 80% cash, and somehow still maintaining enough assets to make delivery. So those were good times. But the miners actually worked out and reached my valuations for the most part in a semi, and I sell those, this was in the spring of 2016, that’s when it struck me. 

The main area where I was finding value, those $0.50 were now close to my fair value and wasn’t really performance-related. We’re having a pretty good 2016 because of the equity returns on the miners. But once I started selling those, I started to get to 90% cash. So now, I’m at 90% cash, and the 10% equity I had left in the portfolio was invested in equities that were close to fair value. But the absolute future returns which I expected were not so great to where I could not achieve that 10% to 15% on even the remaining equities. And at that time in May of 2016 that’s when I recommended returning capital.

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Preston Pysh  3:50  

So Eric on the show, Stig and I, I mean it’s been forever because these valuations since we’ve been doing the show have been sky high. Stig and I are always throwing out a number around 3% is where we think the market is currently priced. If a person would buy in the S&P 500 index. Would you agree with that estimate? Or do you think that the yield is higher or lower than that?

Eric Cinnamond  4:09  

I think it is around 3% free cash flow yield for most of the small caps I fall. My opportunity sets trading around 30 times earnings, and I know where we are in the cycle right now are normalized earnings. So, if you think margins are above average, which means you don’t have to think that they are, but if you normalize those margins, you could argue that the price to earnings on a normalized basis is even higher. I know the Shiller PE’s around 30 as well, which would give you a Shiller earnings yield of around 3% as well. If you use 10 years history rates and you use these artificially low rates, well that’s enhanced earnings. Above where they would be if rates were normal, or real rates were 2% to 3%, instead of 0% to 1%. So I did the math, they are kind of backed into that and came up with a short key that’s closer to 40 times. So I think you could argue if you normalize earnings, and you normalize interest rates, you could actually get to earnings yield but a little less than 3%. 

Preston Pysh  5:06  

I know this is impossible to predict. But what’s your gut telling you for the next cycle? Do you see rates normalizing? Because I don’t. I see them continuing to get pushed down through central banking activities. I get the sense from a lot of smart investors that we talked to that they kind of have a similar sentiment. Do you kind of feel the same way or do you see rates starting to come back up in the next cycle?

Eric Cinnamond  5:26  

I hope central banks are unable to suppress interest rates indefinitely. I mean, to me, though, this would be sad, to where investing as we know it, free markets as we know it, capitalism as we know it, is gone. I mean, it’s very, very sad circumstances. I hope I’m very optimistic that the markets eventually overwhelm the central bankers and take back their rights as investors in investing. I don’t know what you call this environment, but I don’t call it investing. It is too controlling, where you have these central bankers controlling interest rates through the army. It doesn’t make a lot of sense to me that it could last forever. 

But if it does, that’s when I have to find another line of work, because it’s not real. It’s not what we all studied to do. Here you have an industry with thousands of extremely smart people. This human capital, trying to allocate capital to the best of their abilities to find those discounts and put money where it should be placed most efficiently. And that whole process is artificial now. It’s as everyone calls it, malinvestment, you call it what you want, but it’s not natural. I miss the good old-fashioned bubble. Give me the tech bubble, I can understand that one. I was pure green. This one is almost forced on you. You either play along or you don’t.

So I have a tendency to start talking about some of the macro factors. But we’re going to scope this back into what we’re really after here and that’s talking about small cap investing. So I’m going to throw it over to Stig for his first question. 

Stig Brodersen  6:59  

So you started your career in a fund and you started out solely working with small cap stocks. And that’s also a specialty today. How is small cap investing different from investing in blue chips? And could you also in that relation, elaborate on the concept of the small cap police? This is a very interesting discussion that you also have to really understand how the prices are set for small cap stocks.

Eric Cinnamond  7:26  

Obviously, there’s a lot of differences between large caps and small caps. There’s so many more small caps. If you look at large caps, there’s a few hundred. There’s a few hundred mid-caps. Well, there’s thousands of small caps, so I just find that a much more interesting area to work in, where you can find new ideas, maybe things you haven’t worked on before. And I just think there’s more opportunity in small caps. I think there’s bigger dislocations between price and value. And, all that revolves around liquidity. Less liquid stocks are going to move more violently than very liquid stocks where the bid and assets are very liquid.

So there’s a lot of differences. There’s even minor differences when you think about sales. Obviously, large caps are much larger sales, but that also leads to smaller caps having more concentration in sales. There’s little concentration risk found with small caps as well. So there’s a reason small caps, you should demand a higher required rate of return for small caps than the mega caps and the mid-caps. I would say, one of the things I love about small caps is, I feel like there’s more straight shooters. When I listen to a mega cap conference call, I almost feel like after an hour, I just listen to an infomercial. It’s self promotional, but some of the small caps, they crack jokes, [and] are more personal. They tell stories about their business. I just enjoy it more. It’s less scripted.

Stig Brodersen  8:48  

Yeah. And speaking of straight shooters. I guess the price setting in the small cap markets is different from whenever you started your career.

Eric Cinnamond  8:58  

Back then, the largest polars of these small cap stocks were traditional small cap value companies or managers like Royce Funds, Heartland, Valley. There’s a lot of holders, and when prices got out of whack, they were there to police the market. Almost like a market maker, like, alright, now I have an overvalued smaller value stock, we’ll sell it. But now, when I look at the top holders, I see Vanguard, Dimensional Funds, BlackRock. They are the prices, assets, and investors. This is a flip flop from when I started. I know I mentioned this before, but I still think this is what is going to be a significant contributor to small cap opportunity in the future, is the absence of the small cap wheeze.

Stig Brodersen  9:49  

And do you think that the reason for this discrepancy is also that there’s so much more indexing today so you don’t have the same type of rationale behind the pricing for this small cap companies? 

Eric Cinnamond  10:01  

No question. Yeah, the small caps of the index is just as much as the large cap and mid-caps. It’s kind of concerning if you think about this perception that indexing is safer. I don’t think a lot of investors open the hood of some of these ETFs and index funds. Small cap stocks, let’s say, the Russell 2000, when I screen for small cap stock *inaudible*, depending on where we are in the profit cycle, half to a third of these small caps don’t make money. 

If you buy an index fund, you don’t notice, you’re buying companies that are losing money. I mean, you wouldn’t want to do that with your money. But when you index, you’re actually doing that and people get this comfort of diversification. That is lower your risk. I actually think it’s increasing your risk by owning thousands of small cash. Many of them may not be viable businesses in the next few years or the next recession.

Preston Pysh  10:49  

So I love your point there about understanding where you’re at in the credit cycle. We know Howard Marks talks about that in his book about knowing where you’re at in the credit cycle and kind of understanding those forces at play. Whenever you’re looking at the credit cycle, I know a lot of people look at the margin. And I know you’ve brought that up a few times, Eric. What’s the profit margin on the businesses? 

And I think if I remember right, in this last cycle, we saw profit margins get as high as 12%. Is that one of the key factors that you’re looking at to know where you’re at in the cycle, as far as kind of understanding the timing? Are there other metrics that you’re using to understand where you’re at?

Eric Cinnamond  11:26  

So, I remember the mortgage credit boom. I think, 2003 to 2008, that’s when I really became interested in credit and the credit cycle and how that impacts the profit cycle. So when I value a business, I’m trying to normalize earnings. I need to know where we are in that earnings cycle to get an accurate valuation. And the credit cycle is so important to that because the credit cycle influences profits tremendously. 

If you look at the stock market, especially small caps and you overlay that with the profit cycle. What I hear on financial television, I try not to watch much but when I do, one of the main reasons to buy stocks since profits are high. But if you look historically, that’s usually one of the main reasons you want to sell stocks because people are extrapolating record margins and record profits. 

But you go back to margins, why margins are so important, again, I normalize. We just saw Foot Locker announce last week, really poor comps. And it’s amazing what happens to retailers margins, when comps go from plus two, plus three to minus five, minus six. That’s a tremendous amount of operating *inaudible*, there. Their earnings’ expectations fell significantly. Gross margins were down 300 to 400 basis points. So I’ve owned Foot Locker before, but I owned them when the margins were operating margins are over 1%. In most recent years, they were at 13%. So I want to know everything about the business that influences margins to where I can determine that normalized margins, which eventually determines your normalized free cash flow.

Stig Brodersen  12:56  

And Eric, could you please explain that process? You’re talking about normalizing earnings of the cash flows. How do you do that? How many years do you use? Does it also depend on the type of business? Could you please go through with your process?

Eric Cinnamond  13:07  

Now, that’s right. The cycles vary between industries and businesses. So you got to be careful not to just use a standard 5 to 10 year, or 7 year, whatever your number is. When you think about the Shiller PE and I actually talked about this recently with a friend and fellow asset return investor. We talked about this, how the Shiller PE’s 10 years. Well, 10 years, it could include two upcycles and one downside. So now you’re not really normalizing. Or it could include two down and one up. I like to customize my normalization in my period, and customize it to the particular business or industry. And usually, it’s obviously the industry that we look, really.

Preston Pysh  13:36  

I absolutely love that comment. And I don’t think that that’s something we’ve ever talked about on the show before, Stig. That is a really important thing that Eric just talked about. So I would highly encourage people. If you didn’t catch that, you need to listen to that, again, because he’s talking about looking at the size of the credit cycle that you’re in to use that to understand the normalization of what you expect the free cash flows to be moving forward. That’s a really amazing point. 

Eric, is there any other metrics that you’re looking at? We talked about margins, and I know that that one has a very good indicator of kind of understanding where you’re at, at least the charts that I’ve looked at in the past. Are there other things that you’re looking at? Call it the Shiller P/E? 

Another one that I personally like is the unemployment rate, whenever you see the unemployment rate get down to levels that we see today. It hasn’t been there in what? 30 to 35 years or something like that. It hasn’t been this low. I think that’s a really strong indicator that you’re at a market top. Do you have other indicators that you’re looking at?

Eric Cinnamond  14:47  

I’m not the only one that uses this valuation metric, but I always avoid price to sales. It just weeds out so much of the noise and the manipulation in earnings or the financial engineering. I always found it to be a very good indicator. The one thing I learned in the tech bubble is valuations can go to such extremes beyond belief on the upside and downside. Small cap value stocks were extremely inexpensive in 1999 to 2000. I didn’t think they could get any cheaper, then they did. And then tech stocks were outrageous. They couldn’t get any more expensive, and they did. You have to always be careful with these valuation metrics. They don’t really help you with timing, but they help you tremendously with monetary risk in terms of return. 

Preston Pysh  15:28  

Fantastic. Hey, I know a guy who likes price to sales, Jesse Felder. I see him always say that, too.

Eric Cinnamond  15:36  

It’s funny. I bumped into Jesse’s blog and I started reading it and I actually emailed him right away. We eventually spoke on the phone, and we think alike. So that’s a compliment saying that we’re looking at the same thing.

Preston Pysh  15:49  

Yeah. No, and I agree with you because it’s such a raw number. I really like looking at that as well.

Eric Cinnamond  15:54  

You can’t manipulate price to sales. Sales are sales.

Preston Pysh  15:57  

Hey, so going back to the small cap thing here. I’ve got a really simple question, but I think it’s a really important question. And that is, what would you say, are the two biggest mistakes that people make whenever they’re investing in small cap type businesses?

Eric Cinnamond  16:15  

I think one thing is the growth rate. I think the perception is small caps are always these high growing companies. But the ones I focus on actually are slow growers. One of the mistakes I try to limit is using growth rates that are just unachievable, too aggressive. I think growth rates are one of the areas you can make a lot of mistakes because a small cap company in its earlier stages of its life, say a restaurant, does an IPO and they come out with $100 million in sales and they have $100 million in cash. 

Well, you can grow that pretty quickly by just opening new units and using that cash. Up at some point, you’re going to mature, you’re gonna run out of cash, and that growth rate is going to go from 15% to 20%, to 0% to 5%, and that’s when the growth investors kicked the sock out for fooling the value investors *inaudible*. So this is that kind of growth to value transition. 

But not all small caps are biotech companies. There’s so many mature small caps. There are immature industries, and there’s many market leaders in small caps. So I think that’s kind of a misperception by a lot of people. Another thing with small caps, I think a mistake people make is they feel maybe asset allocators more so than the retail investors, but they feel they need a small cap allocation. They must own some small caps. Why? You don’t have to always own something. You don’t have to always own an asset class. 

If the Russell 2000 troughs in 2009 at 350, small caps are extremely inexpensive then. That was last time I was very aggressive, aggressively positioned, but now you’re at 1400. The enterprise value even of the Russell 2000s, like 22 times. I mean that’s twice of a normal takeover valuation. Why do I want to own any bond or index or an ETF or small caps? It’s not necessary. You don’t have to own small caps. I think it’s a huge mistake. But what happens is, asset allocators often look backwards at what is generated, and they use these historical returns and they plug them in their models, and then the model spits out what they should own. But yeah, if you use the last 5 to 10 years of small cap returns, and you put them in your model. And of course, they’re going to look good. But how they act, sure, that’s a whole other story.

Preston Pysh  18:28  

Yeah, because they’re not taking into account that credit cycle that you talked about earlier. I totally agree with you. 

Eric Cinnamond  18:34  

It’s extrapolation with credit, profits, price, the environment. Next year will be different than this year, but with price securities off finesses *inaudible*, they will be the same indefinitely. Not just for the next few quarters, but for many, many years. If you like the value of a stock, most of the value of the stock is many, many years away. If you value a long term bond back when we had interest rates, most of the value was 10, 20, or 30 years. If you bought a 30-year bond, most are the values many, many years away.

Stig Brodersen  19:04  

So in continuation to this, I would really like to talk more about the cycles. And I really can’t remember who we had on the show. Perhaps it was either Bill Miller or might be Jim Rogers, who talked about the danger of starting your career in a bull market, which is kind of like a funny thing, because I guess most people will say, “That must be great. Everything’s going up.” You feel invincible, right? 

So Eric, I know you started your career back in the ’90s, where everything was going up. And today, you have a lot of experience under your belt ,and now this is your third cycle. So, I’m curious to hear what you learned from each of these cycles, and if you also feel that it might have been a disadvantage for you, that you began in a bull cycle.

Eric Cinnamond  19:47  

Oh, no question. I mean, that is a great point. 1993 to 2000, for most of that cycle, everything I touched turned to gold. It was unbelievable. 1993 to early 1998, I mean, I just graduated from college. I was running trust money, like $300 million. I couldn’t believe they’d given me all this money at that time. It was incredible. And I was doing well. And then in 1996, I joined Evergreen Funds as a small cap value manager, and the trend continued. Everything I bought went up. Not everything, but almost all. I felt like everything would work out. But it was, I talked about this with Jesse. It was the profit cycle that I had no idea was my first cycle. I mean, I was this young analyst, and I thought I was a genius and it was great. 

But then, of course the tech bubble hit and that, wow, that was a humbling experience where I went from the genius to the idiot. That was a very, very difficult cycle. So I was talking about 1999. I’m most proud of that year because I lost 8%. I don’t know if you tried, if you could lose 8% in 1999, but somehow I did it because I bought a tech and bought some *inaudible*. But Bill Miller was right in that. Jim Rogers as well, where you start can influence how you perceive yourself and how others perceive yourself. 

Preston Pysh  20:31  


Eric Cinnamond  20:38  

And if you think about the average age of an analyst to manager now, I would guess it’s 8 to 10 years, maybe. What’s the cycle length of the cycle? About 9, right? 

So it’s interesting. A lot of investors now are running billions and billions, maybe trillions of dollars. They’re in the same position I was in, back in the ’90s, when I thought I could do no wrong, and I was bulletproof. And that’s kind of scary. Good thing I wasn’t running a billion dollars back then. I could have hurt somebody. In fact, in 1999, I did lose 8%, but that kind of loss, you can recover from, and I did. But the losses that could occur in this cycle with where valuations are, these are types of losses, especially if one of the reasons the market goes down is loss of confidence in central banks, because then who’s going to bail out the next cycle. 

But if you just revert to normal valuations, you could lose at small caps, half your capital. That’s not down 8%. That’s going to be really difficult to recover from unless you have another bubble. And how do we gauge we have these bubbles every 5 to 10 years. I mean, is that what we’re actually relying on to make investment decisions now? I’m overpaying because I know they’ll bail out this one to build another bubble down the road. That again goes back to this investment.

Preston Pysh  22:22  

It’s an interesting point that you bring up about people having faith or trust in the central banks moving into this next downturn. I personally think that that’s going to be a lot of the questions that are going to be asked. I really hope that I’m wrong, but I really think that that’s going to be the thing that really drives the panic that we’ve always seen in these cycles. But I’m kind of curious, would you agree with that, Eric? Or do you kind of see maybe some other things that could potentially cause the panic?

Eric Cinnamond  22:48  

It’s been so long since we’ve had panic. I think once it happens, it’s going to be so new to so many people that even people that are experienced, they haven’t seen it in so long. I mean, when you’re losing 10%, 20% or 30% of your money or your client’s money, that’s frightening. I don’t think people are even considering this. But when you look at valuations, why should you be considering it? History suggests you shouldn’t even just be considering it, you should be counting on it. And this is very normal for bear markets. The amount of money that’s indexed now and how price *inaudible* many of these assets are. 

For us, for disciplined value investors, I think the end of the cycle is going to be extremely profitable. If you have liquidity and you may take advantage of it. But if you don’t, how will you now get capital [if] you don’t have to allocate? It’s already a mess. 

It’s tough. Everyone thinks they’ll be the first one out when a cycle ends. Like, when you ring the bell. But even with small caps, if you’re running a billion dollars in small cap money, and the bell rings, and the Russell 2000 drops 30%, I have news for you. You’re not getting out. You’re not going to be the first one out. It’s not possible. You’re going to ride it down.

Preston Pysh  23:59  

When you go back and you look at 2008, I was looking at it week by week just to understand what that panic looks like. And, in a week, you were seeing 12% to 14% pull backs, and you saw it for a month straight where you saw those numbers. So this stuff hits so fast and so hard. And then the mindset, the psychology of the person who’s experiencing that is, if I just lost $10,000. I just lost $30,000. And, for a person who might have a $100,000 portfolio, they’d be saying these things to themselves. They said, “I can’t sell these positions because then that becomes real.” And so, I said, “I’m just going to hold, and I’ll wait it out.” 

And you know what that turns out to be? That turns out to be 8 years later, they got their principal back, or 5 years later, or whatever it be. So what they’re really paying is they’re paying for the time and the lost time that’s coming in the future for them to get that principal back. It’s a whole lot harder from a psychological standpoint if you’ve never experienced that before.

Eric Cinnamond  24:59  

That’s right. If your position, if you’re fully invested right now, which you know, mutual fund cash levels are 3%. Frank Martin did a great blog last week about this. He’s talked about how cash levels are 3% on average for equity mutual funds. Meanwhile, there was a survey that showed portfolio managers, 80%+ of portfolio managers believe stocks are currently, I think it was as expensive as $2,000 by year 2000. So you have a huge conflict here. 

On one hand, the professionals are fully invested. On the other, they think stocks are overvalued. So if they think stocks are overvalued, and they start losing 10%, 20% to 30% of their client’s capital, I don’t know how they’re going to respond. Because they know, stocks are expensive, I think they might be a little quicker to sell. And then, if they firmly believe there was value, they had margins of safety, but they don’t. And I think they know that. I mean, this survey shows that. 

Preston Pysh  25:57  

So Eric, one of the things that I struggle with, when looking at small cap businesses is finding the financials that are somewhat stable and therefore calculable whenever I’m looking at trying to figure out what I think the intrinsic value of the business is. So, I’ve often had just very little confidence in the small cap arena. I see myself gravitating more towards mid and large cap businesses because I see the stability in the numbers ,and I feel like I can come up with a better projection of what the free cash flow is going to look like moving forward. Help me understand how I can improve my process, and how you look at the small caps. When I’m reading your blog, I see that you said that you did 200 calls, 200 assessments in a quarter. I mean, you’re reading all these financial reports. I mean, you’re really down into it. So, help me understand how I can maybe improve my approach with small cap.

Eric Cinnamond  26:49  

I think if you follow more mature companies, less exciting companies. I’m always looking for that sort of perpetual bond type of business, and they’re not really trying to impress you. Just try to go 3% to 5% a year, that sort of high single digit, maybe 10% return on capital. They’re not exciting companies. And that’s what I want. Because my whole absolute return process revolves around limiting mistakes. And I focus on those companies that are more mature, less likely to surprise me on the upside or downside, or both ways. 

So I think that is helpful. Focusing on companies with long operating histories. And over time, if you follow the same names for, say, 20 years, you get to know the companies that are promotional. You kind of get to know the managers that are sort of the Eddie Haskell’s in the world versus the straight shooters. So that takes time. Another thing I’m thinking about just now was you could even focus on closely held businesses. Closely held businesses, people often put discounts on those, but I disagree. If the closely held businesses are being run properly, they don’t tend to financial engineer as much because why fool yourself? You’re the majority shareholder. There’s no reason to participate in financial engineering. 

But you’re right. It does happen in small caps, but I would argue it happens as much or even more in the larger cap names. I think small cap companies often learn from the bigger market caps what’s acceptable and what isn’t. And a lot of them will imitate that. I remember early in my career, we didn’t have these non-GAAPs, where you have 20 footnotes. After the press release, there might be one or two footnotes. But now, it’s half the press release’s footnotes on how to explain their non-GAAPs. So it’s definitely gotten out of hand, but with all market caps.

Stig Brodersen  28:40  

So, Eric, do you find that small cap businesses in many ways are easier to analyze and large cap businesses, simply because the business model might not be as complex, and also because many small cap companies as you also touched upon, that’s not necessarily a biotech company, or something that’s just growing or is just failing. It also might be family-owned businesses that’s having a stable track record for, call it, not even a few decades, but perhaps even more than that.

Eric Cinnamond  29:09  

That’s right. So these, again, are very mature companies that have been for many cycles, and that allows you as an analyst to analyze how the business will respond to many different environments. That goes back to normalizing cash flows, determining sort of that margin range, very important. And history is one of the best ways to do that. The longer history, the better. I rarely buy IPOs, new *inaudible* public. There’s just not a long enough history for me to get a good feel for where I should expect margins and cash flows.

Preston Pysh  29:42  

Eric, I got a question for you. So, when we’re trying to filter through finding the best picks on the market, a lot of the filtering that we do is this EBIT to enterprise value, when we’re trying to find things. What are you using as a filter to find new companies in your mix?

Eric Cinnamond  29:59  

I have a formal screening process. It starts with market cap. It’s $100 million to $5 billion. And then I put a profitability hurdle on that. And it’s 1% ROE [return on equity], and you’re like, well, that can’t be hard to exceed that hurdle rate. But you’d be surprised with small caps. Again, we talked about this earlier, depending on where you’re in the market cycle, a third to a half of small caps don’t make money. So that eliminates about half. One thing I don’t like using earnings, like a P/E then even enterprise value EBITDA, but I do like enterprise value EBIT better than P/E for many reasons. But I want to be careful not to weed out cyclical companies that are generating trough operating results. 

So there’s a lot of high quality cyclical companies. I wrote a post called “Great Coupon Investing”, and I kind of poke fun that maybe value investors. Their opportunity set is so narrow because they only buy a certain type of company. But there’s so many opportunities and cyclical businesses, if you can get over the fact that the operating results are just naturally evolved. There’s nothing wrong with that if you can normalize, and they’re profitable throughout a cycle, and they have good balance sheets, that sometimes turns off a lot of investors, which I think creates opportunity. So I try to avoid screening by P/E. So I just want a minimum that they can make money. It’s a very low rate *inaudible*. 

So the market cap often *inaudible* rate, but then I apply a leverage filter, and I want these companies to have less than three to five times debt to discretionary cash flow. My reason for small caps, and small caps aren’t like mega caps that you can borrow for 30 to 40 years. If you look at most small cap debt, it’s more than the maturity loss 2020. It’s more like four to six years max. So, I want to make sure that they can pay off their debt with cash flow if needed, versus depending on a fickle banker or a moody credit market. So after that debt screen then I have, believe it or not about 500 names, and about half of those already in my bio list, right? 

So I’m so familiar with many of these, and then I sort through the remainder, and there’s probably 100 or so that I’ve worked on and will not own for one reason or another. It could be management, tackle allocation strategy, as many reasons. And then, you know, maybe once every month, I get probably even one or two names a month, so it’s not as much as you think. 

And those replace many of the companies that were either acquired, or may have violated my discipline for one reason or another. Another way I screen for stocks is I do role playing, where I’m trying to pretend I’m a relative return manager with a really big house, country club membership, big cars, a yacht and running a billion plus in relative return money. 

And then I think to myself, all right, I’ve got 10 very large consulting meetings next week. What do I not want to talk about? Right there, that is usually one of the best ways to be a contrarian and come up with contrarian ideas. And right now, where would you look? I would think you’re approaching that sort of the end of the year where there’s performance anxiety, that you’re in performance panic. I think you might want to start looking at energy. 

In retail, I think those might be the two most embarrassing sectors in the market right now to own for professional managers. And when professional managers, they have this, I call, perception risk, when they feel that they may lose assets, or just talking about maybe owning some of these things. I think that’s sometimes you can find tremendous value, just sort of role playing as if you’re a relative return manager.

Preston Pysh  33:47  

So I love that comment. That’s amazing, because we had a conversation last night, Stig and I. And I was talking about Target. I think if you brought up Target or Walmart or any of these retailers to anybody right now, they’re going to think you’re a total idiot. With all the news and everything that Jeff Bezos is making in the market. And it’s funny that you say that because I think that is a great way to think about this as how would you be scared to talk about something in a meeting with consultants, and that’s probably where you need to be looking the most. That’s an awesome comment.

Stig Brodersen  34:23  

So Eric, once in a while, Preston and I talk to each other about stocks that we’re looking at. And lately, we’ve been talking about retail. Probably Target as Preston mentioned before. And of course, we have this huge threat from Amazon that everyone’s talking about. How do you see margins? And how do you see that in relation to the cycles that we’re talking about? Do you see the margins just going down from now and just keep slipping over the next decade? How are you seeing this?

Eric Cinnamond  34:50  

I think it’s difficult to determine right now because we haven’t seen a recession in so long. Everyone is so focused on Amazon, but if you go back to the last cycle, If you go to 2008 to 2009, and you look at retailers or suppliers’ retailers, and you look at their margins and what happened, there’s a tremendous amount of operating leverage when sales decline for retailers and their suppliers. I remember when Hanes brands, there were no single digits in stock. They had some debt. If an underwear company can lose considerable sales in a recession, a lot of different issues, you name it, that are more discretionary and see the cons as well. 

So right now, I don’t own retailers, they’re becoming interesting. But you know, I view retail as a cyclicals. We talked a lot about cyclicals today. So I think that’s really interesting. I’ve never *inaudible* retailers, but if you view them as cyclicals and then you take into consideration those margin ranges, again, I think you’ve got to throw in a scenario of a recession, not just the Amazon. Right now everyone’s focused on Amazon and they’re not really thinking about the next recession, which I think will have a greater consequence to margins.

Preston Pysh  35:56  


Stig Brodersen  35:58  

You talked about how you have 200 or 300 stocks on your buyer list. I mean, how are you reading through all those earnings reports? I assume that you go in depth but also assume that you must have some kind of a filtering process for you to have time to go through that many reports. What is your process for doing that?

Eric Cinnamond  36:17  

I read the reports and the conference calls. The calls I can get through pretty quickly. You can’t listen to them, all of them, it’s impossible. It will take too long. I’ve learned how to read these very quickly and find out what’s important. Some of the questions analysts are often very predictable, while some analysts are sort of asking some of the same questions, and you can often breeze through some of those, if there’s something that’s not important to you. So I have sort of worked on that. It’s not speed reading, but it’s weeding through what’s important, and what is just standard. An analyst asking a question to help them fill out their model, right?

Preston Pysh  36:53  

What’s your number one tip for reading a 10-K or a 10-Q?

Eric Cinnamond  36:57  

Know where the important information is. The 10-Ks are so thick now because of regulation below the requirements now. They’re putting information that always ain’t beneficial in helping you value a business. But I like to go to a description. It’s very important. The beginning is very important, and then I like to go to the financial statements in the footnotes. The financial statements are invaluable. That’s why you need more than one 10-K, you need a whole cycle of 10-Ks. You don’t have to print every year, but every three years, and that can give you a profit cycle if you read those 10-Ks, and help you get through the profit cycle. You should be able to come up with a rough valuation just on a 10-K. 

One of the things that I always stress for investors that I get asked a lot, what’s your favorite investment book? Which one is most valuable for you? And it was, “The Analysis and Use of Financial Statements”. And that was something I read in the early ’90s when I took the CFA program, and that book was invaluable for me just to become literate in reading financial statements. It is very good.

Preston Pysh  37:59  

Eric, I want to talk about cyclicals because during our Mastermind discussion that we just literally had the other night. This came up as a really nice theme. We were talking about Fiat Chrysler with Mohnish Pabrai. And that he bought in at $4 a share and then you know, popped the ton. And we were looking at the timing of whenever he would have done that. And I think you hit on this a little bit tonight. 

As far as understanding when the margins are really low on a cyclical [basis, then] that’s probably the best time to enter that position. So today, here in 2017, in the summer of 2017, we’re seeing probably some of the largest margins. We’re seeing the inventory build on the automobile industry. Would you classify this as being the absolute worst time to be investing into the automobile industry?

Eric Cinnamond  38:46  

I cannot comment on the automobile industry. I’m sorry. I do call a few suppliers, and they’re not seeing trough results yet. They are seeing declines, but they’re low single digits, nothing like you’ve seen in a recession. They would not know as soon as an actual manufacturer, but just to touch on the cyclicals. I find tremendous value cyclicals because there isn’t a home for them for a lot of investment portfolios. Growth portfolios don’t like them. Well actually growth portfolios like them when they are generating cyclically peek. 

A lot of value investors don’t like them because they’re ugly, and they get a lot of difficult questions and consultant meetings. I can’t tell you how much consultant meetings impact our portfolio managers on money. It’s almost like, what’s the consultant going to think if I buy an auto manufacturer, or an energy company. I found at least over the 18 years I’ve run the absolute return strategy [that] where the areas have found tremendous value was in commodities. 

However, a lot of high quality value investors, they just won’t even consider commodity companies because we’re taught in school and in all the great books that they’re bad businesses. But if I can buy MCF, a natural gas in the ground for $1, and it costs $2 to finally develop that, or if I can buy an ounce of gold in the ground, fully developed for $150 an ounce, and it costs $300 an ounce to fund and develop that. 

Those are things I’m interested in. I view commodity businesses more from valuing the balance sheet. Most of what we talked about earlier about normalizing cash flows and most of my valuations are perpetual bond type valuations. But how I value money or assets or heavy companies are very different. Where I want to buy their balance sheets at a discount. I want to buy the natural gas reserves, the oil reserve, [and] the gold reserves at a discount to what would cost to replace them. And that has worked very well for me over time if I can buy when no one wants them. 

Commodity stocks are usually, and this applies to cyclicals as well, they’re usually extremely overvalued or extremely undervalued. Rarely are they right in the middle. And rarely are they fairly valued. People want them or they hate them. I think now, energy’s starting to get a little more interesting. And the precious metal miners have had quite a run since their trough in early 2016. I think a couple of those are also interesting as well. 

So I’m focusing more now on asset heavy companies where I’m finding discounts on their balance sheets versus discounts on a free cash flow, perpetual bond valuation, because those are made very expensive with rates so low, right? Because you’re buying those as a bunch of bonds onto *inaudible* in these extraordinary low discount rates and buying those businesses. 

Preston Pysh  41:30  

So when you say a discount on the balance sheet, describe what that means to the listener. 

Eric Cinnamond  41:34  

Well, let’s think about a miner, a new gold mine. And I’m probably going to turn off half your listeners on metal miners. My apologies. 

Preston Pysh  41:43  

No, not at all. 

Eric Cinnamond  41:44  

So the New Afton Mine is a very profitable one, very nice mine. And what it would cost to replace that to bind the land and to build a mine would probably be around a billion dollars. And their Rainy River mine is almost complete now. 

You know what they paid for the land. They bought it actually when prices were a little lower. That would be probably $1.3 to $1.4 billion to replace that money. That’s a new mine so you can get a very accurate valuation on the replacement cost. They have a mine in the US. They have a mine in Australia. And they have the Blackwater property in Canada.

Also, they’ve done a feasibility study there where you can get a range for the value of that mine. So you add all that up, the mines for the replacement cost of those mines, subtract the billion debt, they’ll have maybe a little less than of cash, once the River’s complete. And then you come up with what that balance sheet’s worth on a replacement cost. 

Same thing with energy companies. Energy companies, you’ll have proven, developed reservers. And those you know what it costs to buy the land. You know the cost to drill. You know the funding development expenses. Again, if I could buy oil in the ground that’s already developed for $10 a barrel, and it cost me $20 a barrel, if I were to do it myself with a rig in buying the land, well, I might try to buy the stock. But they have to have a good balance sheet. So this is the key. And this is what helped me survive the bear market in mine stocks in 2014 and 2015. 

You need a runway and you need to determine what is in a perfect runway. It doesn’t matter if you’re buying a $0.50 if the company doesn’t survive. You look at Tidewater. It’s a good example. They’re the market leading energy service company with the vessels out the oil rigs. They had a $50 book value a share, and it went bankrupt. I mean, tremendous assets over 200, almost new vessels, but it didn’t matter because they didn’t have the necessary liquidity and the debt covenants kicked in. They went to bankruptcy.

Preston Pysh  43:37  

I’m trying to think of a simple way to describe to our audience how you’re describing this. Would it be appropriate to say that, to think of the price of the company that what it’s trading for versus the book value of the company with the equity. If we’re looking at that ratio of the price to the book, and we look at what would be on the far left versus on the far right. 

Let’s say that historically, the lowest it’ll usually go is a price to book of 0.7. And then on the high end, maybe it’s a 3.0. Whenever you see things sliding to the left, and it’s getting close to maybe a 1.0 or lower, you’re buying off of those factors that price the book factor almost exclusively. Would you agree with that?

Eric Cinnamond  44:17  

That is very similar to what I do. However, I do adjust the book. So it’s sort of an adjusted book. You can have, say, for Pan American Silver, their El Colorado [La Colorada] mine. I’m probably mispronouncing that, apologies. That mine was built in the mid ’90s. So the cost basis on that mine, I think last time I looked, was maybe $800 million. There’s no way to replace that mine for that type of price, because it’s on historical costs. I value that mine closer to $600 million, based on their current reserves and their current production. 

You could go the other way too, where you can reduce the value of the mine or the reserves. A really simple way to think about it is, I apply this to financial companies as well. I do not use just kind of cash flow for financial companies. I’ve rarely [invested in] banks, because they usually trade two times book small cap in banks. They don’t make a lot of sense to me. 

Why would I want to buy a book of mortgages at twice the value? But in a crisis, I didn’t buy a bank or two, but they were trading at discounts to board. So I think anything from the financial business perspective, it’s a little easier to think about the energy company or precious metal miner.

Preston Pysh  45:24  

Just fantastic information. I really appreciate that discussion, Eric. We’re just thrilled to have you on the show. We can’t thank you enough for making time out of your busy day. If people want to learn more about you, Eric, I know that you’ve got your blog there at ericcinnamond.com. We’re going to have a link for that in the show notes, but where else can people find you if they want to reach out and ask you questions or anything?

Eric Cinnamond  45:47  

My email is on my website. Feel free to email me. One of the great things about the blog is the amount of people I’ve met, so far like-minded investors. What I recommend is sending the capital back. Yeah, I felt like I was the only absolute return investor remaining in the world, but that’s not the case. There’s a lot of us out there. It almost feels like the silent majority. There’s so many that think like absolute return investors, but they’re forced to invest in the relative world, and I think that’s interesting. Please email me. Also, I make available the quarterly management commentary for my small cap companies. I get a lot of emails requesting for that, so I’m always happy to send those out. 

Preston Pysh  46:25  

Oh, that’s fantastic. Thank you. We really enjoyed this conversation. I know our audience is going to eat it up.

Eric Cinnamond  46:31  

Thanks, Preston and Stig. Thanks a lot for having me. I really appreciate that.

Preston Pysh  46:36  

Alright, so at this point in the show, we’re going to play a question from our audience. And this question comes from Sammy.

Sammy  46:41  

Hi, Preston and Stig, longtime fan, this time corner. I really appreciate everything you guys have done. I’ve been recently just getting into value investing, and everything that you guys out there is awesome. I’ve listened to every single podcast and I hope you guys can help me out and answer my question. So to keep it simple I’m Vif. I’m from the UK. Recently, well, the word applies mostly, that it’s hard to find value picks. 

A company that I’m looking at, Debenhams, it’s a retail company. And my question isn’t specifically for Debenhams, but in general. If a company is declining in income, as in net income in the recent years, and the stock market has seen that and therefore has reduced its prices, and it’s gone down to a certain point that it seems like a value pick, because now it’s undervalued, would you still invest in it? Thanks for your help.

Preston Pysh  47:41  

All right, Sammy. So I really like the question. And the reason I like this is because you’re talking specifically about the bottom line. You’re talking about the net income of the company and the profit that it’s producing. Whenever I hear somebody say the net income’s decreasing. It’s going down, and the company’s getting penalized in its stock price because that net income’s going down. 

One of the very first things that I want to look at is the top line of the income statement to understand if this is something that’s being generated because the company has lower sales, or because maybe the company’s expenses are growing, or maybe a combination of both of those things might be causing the net income to go down. Because whenever you understand what’s happening on the top line, and then you work your way down the income statement, you have a much better idea and interpretation of what’s going on at the business. 

So, let’s take an example. Let’s say that we have Company X, and you were saying that the net income was going down. But let’s say that the revenue, the top line of the business is also going down at about the same rate as the bottom line. When we would see this scenario play out. What that really is telling me is that the company is losing market share. This is telling me that the assets that the company owns are not as competitive as what they were in the past if that trend is continuing to go down on their top line. This is really, really important. 

So if you don’t fully understand what’s happening to those assets and why they’re losing their market share to some competitors, that’s a red flag, that’s something you absolutely have to understand as an investor, because if that continues, if that trend continues, it might be a value pick all day long. But eventually it might turn into a bankrupt company, or you might lose a ton of money on the price that you were buying it because it continued to go down in value a lot more. 

So I would tell you, you got to understand what’s going on with the top line. And just so everyone in the audience understands what I mean by that. Whenever I say the top line, so if we’re talking about a company called Coca-Cola, the top line would be, you sell one can of Coke for $1. The top line is $1. 

Then after you talk about the cost for the metal to make the can, the cost of the sugar, the cost of all the employees, the cost of all those things, the facilities, all that kind of stuff, it’s subtracted out of that $1 price and at the bottom, you’re left with maybe $0.07 or $0.10, or whatever the margin is at Coke, and this is after taxes. That’s how you kind of understand what I’m talking about here from top line to bottom line. So I’m curious what Stig has to say on this one.

Stig Brodersen  50:10  

So Sammy, I think that the keywords here in your question, that’s valuation and declining earnings. Because clearly as an investor, that’s not what you want to see. But it’s always a question about what kind of value are you getting for what you’re paying for. So let me just give you an extreme example. And I know it might sound a bit silly, but imagine that you have a stock and it makes a million dollars per share the first year, and then we have declining earnings of $100,000 each year. Now, clearly, this won’t be good because you have declining earnings, but say, you can buy that stock or $1. 

I know it’s a silly example. Yes, that would be a great investment because you would get so much back. So that’s the first thing that you need to look at. You’re specifically talking about real sell copy *inaudible*, but the process is really the same. You’re basically just discounting the future cash flows, whether or not they’re declining or not. And then you compare that to the price today. I think the main problem I have with companies that have declining earnings is that they’re often harder to value. I’m not talking about the math here, because the math is basically the same, but it’s harder to estimate the cash flows in the future. 

If you do see a company with declining earnings, it might mean that they have lost competitive advantage. They’re losing market shares as Preston also pointed out. So it’s just harder for you to come up with a good estimate, and in valuations you would like to have a better estimate. It’s possible so you can ensure that you will buy it at a discount. I think that’s my main concern about planning earnings. It is not in itself that it is declining. It’s all compared to the price.

Preston Pysh  51:47  

All right, Sammy, so really appreciate you asking this question. And because you asked this question, we have a very special gift for you. Stig and I have designed and recorded this, took us a long time to do, but we’re finally done with this course. And the name of the course is the Intrinsic Value Course at TIP Academy. 

And we’ve been working on this one for so long, and we’re really excited to give it to you completely for free. You’re going to learn about what we just talked about plus a whole lot more all in video based format. So we’re really excited to give this one to you and we really appreciate you dialing in and leaving your question for us. 

All right, so if you want to get your question played, like our guests here, just go to asktheinvestors.com. And if you go to asktheinvestors.com, you will see there’s a little recorder there. You just hit record and you can ask your question and then it goes right into our queue. And if we select it and play it on the show, you get access to one of our courses.

Stig Brodersen  52:42  

Alright guys, that was all that Preston and I have for this week’s episode of The Investor’s Podcast. We’ll see each other again next week.

Outro  52:48  

Thanks for listening to TIP. To access the show notes, courses or forums, go to theinvestorspodcast.com. To get your questions played on the show, go to asktheinvestors.com and win a free subscription to any of our courses on TIP Academy. This show is for entertainment purposes only. Before making investment decisions, consult a professional. This show is copyrighted by the TIP Network. Written permission must be granted before syndication or rebroadcasting.


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