9 June 2018

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, Preston and Stig 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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  • How margins move in the business cycle, and where we’re currently at.
  • What to listen for in an earnings call.
  • Which catalyst that can make inflation take off.
  • Why the recent movement in Treasury bond yields are important to your portfolio.
  • Which sectors are priced attractively and where not to invest.


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, how’s everyone doing out there? On today’s show, we bring you the master of small cap investing Mr. Eric Cinnamond.

Eric has been an investor for two and a half decades. His approach is very different from most people we interview. Instead of analyzing the companies that most people pay attention to, Eric is down in the trenches looking at the 10Ks and 10Qs of businesses under a billion dollars. 

Eric is listening to over 100 conference calls per quarter. He stays totally immersed in the part of the economy where the rubber meets the road. 

On today’s show, we talked to Eric about the common themes he’s hearing on the quarterly meetings. We also talked to him about how he determines the intrinsic value of a small-cap business. 

In addition to that, Eric also provides some interesting comments about the current market conditions so sit back and get ready for a highly informed and thoughtful Eric Cinnamond.

Intro  0:56  

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

Preston Pysh  1:17  

All right, welcome to the show, Eric Cinnamond. Always awesome to have you. We were really looking forward to recording this one. 

Eric Cinnamond  1:24  

Thanks, Preston. Thanks again for having me back. I really appreciate that.

Preston Pysh  1:28  

It’s great to have you here. The last time you were on the show, you had briefly mentioned your typical day of conducting research. I would like you to kind of talk about this idea a little bit more to our audience so they can kind of get an idea of how diligent you are because I’ve read some of your reports that you send out. It is absolutely mind-blowing the amount of research you do, and how much attention to detail you pay to so many companies. 

Talk to us through the quarterly calls. Tell us about the volume, like the number of calls that you listen to. Just kind of walk us through your day of research.

Eric Cinnamond  2:05  

I guess it depends where you are in the quarter. A lot of time lately I’ve been doing maintenance research, which is going through all of these quarterly conference calls and earnings reports. That takes about six weeks to get through about 200 calls.

They are all 300 names, but they’re in different fiscal years. Some of them are about 200 calls. I can get through maybe 20 days sometimes. It’s a lot of reading. 

Fortunately, these are smaller cap companies. They’re a little easier to understand.  Their calls are about an hour. However, for the businesses themselves, it’s a little easier than say, trying to figure out General Electric back in the heyday,

Preston Pysh  2:43  

You’re listening to so many calls and I don’t know anybody that listens to this volume of calls. When you say you’re listening to that many calls, can you pick up immediately if there are problems in a business because you’re listening to so many calls?

Eric Cinnamond  2:57  

I should mention that I read most of them, so I have transcripts. However, it is important at times… When I was writing the portfolio, my top holdings, I would tend to listen to those. 

I think the tone is important when you’re really trying to understand what management’s trying to communicate. The routine, again, is 10 to 20 calls a day, getting a better understanding of the businesses, getting a better understanding of what is going on in their current environment. 

It’s not a lot of valuation work. I’m really trying to get a feel for where they are in their profit cycle, what are the variables that are currently impacting their free cash flows in helping me better understand the business and helping me better value the business,

Preston Pysh  3:38  

You feel like you have a better idea of how a certain industry is moving because you listen to these different calls?

Eric Cinnamond  3:45  

Yeah and then you get a better feel for their suppliers, their customers, the vendors, and what is influencing again, their margins at the time.

Just think about right now, the trucking industry. The cost of the trucking industry is growing 20%. I do follow most of the truckers so you can listen to their calls and get a feel for what their customers are going through. 

Then you get on their customers calls and you’re *inaudible* his rates are going up 10-20% on it. So you can triangulate quite a bit in the raw material costs, you can follow some of the suppliers of companies and some of their competitors. 

I find a fixed opportunity set. Not only do you get a good feel for all the different industries, but you get a good feel, again for their customers, suppliers, competitors, those sort of things, which again, I think helps a lot in valuing these companies.

Stig Brodersen  4:36  

Yes, Eric. Let’s continue this discussion about valuations because I guess what most investors would do and with good reason is that they will look at the past 5 or 10 years and then they would use those cash flows and discount them and come up with intrinsic value one way or the other. 

I know that we also need to consider the business cycle right. That’s something that you have been doing for a long time because if we all say at the peak of the business cycle, those earnings might not show the right picture of the true value of the company. Could you talk to us more about where we are in the business cycle?

Eric Cinnamond  5:13  

I think we are similar to 1999 and 2006. Profits are extremely high. Demand is strong, on average. There are certainly some industries where it’s not as brisk, but I mean, interest rates are showing us this. I think right now, in that if we go higher from here, given the tightness of labor, the tightness in the economy, I do not believe interest rates are going to cooperate. 

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Preston Pysh  5:38  

What would be the indicator for you that we’ve transitioned to the next phase? Margins dropping, unemployment starting to rise?

Eric Cinnamond  5:45  

I just had this conversation with Jesse. It’s kind of interesting. I think some people believe that rising inflation will crimp margins, right? I don’t think that is so. I’m seeing margins actually hold up, because I think you’d be able to pass on price increases. 

What I’m envisioning is interest rates ending the cycle, right? Higher discount rates, because you can have these 100, 200, 300 increases in discount rates and multiples stay where they are. It makes absolutely no sense. 

So I’m not a believer that the margins are going to decline initially, because of rising costs., but I believe rising costs will be the catalyst for higher rates, which will be the catalyst for the end of the market cycle, just like the past cycles.

Then you have margins impacted once the cycle ends, right? I don’t see profits ending the cycle. 

We saw that in 2015-2016, where we did have a profit recession and the cycle didn’t then. It hung in there pretty well. That was because rates stayed low. Remember, there’s no alternative. That was going strong then. 

When rates go up, again, to 300 basis points that these levels and these valuation multiples… That’s a considerable risk that I think eventually will impact margins, but it’ll be because of demand, not price and not cost.

Preston Pysh  7:08  

So back to the trucker comment. What’s the main driver for the 20% increase?

Eric Cinnamond  7:14  

Labor is a huge issue right now. We have a huge labor shortage. They just implemented some electronic logging regulations so it’s making it much more difficult for truck drivers to, lack of better words, to cheat on their hours. 

There’s a huge labor shortage. If you want to make  a good living right now, if you’re out of work, absolute return investor, you could pick up truck driving right now. It’s a very good occupation to go into right now.

Preston Pysh  7:40  

As a person who listens to all these calls, what’s your comment on the Elon Musk call that happened just this past week where he didn’t even want to answer one of the analysts questions? As a person who listens to so much, how would you interpret that? Is this just noise or is there something to this?

Eric Cinnamond  7:59  

Yeah, I wish I could comment on that. That’s a little out of my league.

I can relate a little bit to some of the sell side analysts and some of these calls. Some of the questions are, they’re not irrelevant, but they might be more towards, “Hey, can you fill out my model for me?”

I’ve seen where management at times is like, “Come on do your job. You’re the research analyst. I’m just supposed to fill it in for you?”

Yeah. So I could understand where there would be a point… I don’t know if that was the point. Again, I don’t follow them, but I can understand where someone could lose their patience for some of the questions. 

There’s a lot of good questions, but again, I’d say every call has that guy who is asking management really fill in their model in a direct way.

Stig Brodersen  8:45  

Now, why only small caps? I mean, we just briefly talked about Tesla here that you don’t follow. One of the reasons might be because it’s not a small company, but why not follow all the big companies too or some of them? I’m sure there would be mispricing there as well.

Eric Cinnamond  9:01  

You really could I mean. You could apply absolute return investing to all market caps and you could do international as well. But I found by having a fixed opportunity set, that’s really allowed me to get to know those businesses well.

We go back through going through all these companies every quarter, I think if I was starting from scratch, and I just started following these companies, that would be much more difficult. That’d be much more challenging to understand these businesses well.

I wouldn’t be able to go through some of the calls. I read them all, but there are certain questions that I’m like, “Okay. I already know this.” You just move on and you can get through more calls quickly that way.

Preston Pysh  9:39  

Let me ask you this, what are the top two or the top three big trends that you’re hearing on all these different calls?

Eric Cinnamond  9:46  

I would say the biggest trend I’ve really started to notice in 2017 is rising corporate costs wages. The ability to pass on rising costs is also new. I think the psychology has changed in corporate America, that now it’s actually acceptable to ask your customer for a price increase. 

2015 to 2016 was a lot different. It was disinflationary. That shifted in 2017 and we could talk more about why that shift occurred.

Another trend I’m noticing is business is pretty good. It’s interesting that I’m still uninvested, but overall, the companies I follow are doing fairly well, so I’m not really bearish on the operating environment. 

In fact, I think things are pretty tight right now. I’m noticing more mentioning of capacity constraints, inability to find adequate labor, the type of things you would see, at the end, or in a part of the cycle, that is pretty healthy. Things are going pretty well for most companies right now. 

Preston Pysh  10:52  

Would you say that the inflation is getting a little hot or is it just healthy at this point?based on the calls?

Eric Cinnamond  10:59  

I do not think we’re currently in some sort of runaway inflation mode. However, I think the trend has definitely shifted. A lot of the price increases I’m seeing are in the low to mid single digits. It’s not outrageous, but it’s there. 

To me, it’s very obvious.  I’m fairly certain I see it building in the pipeline so when you are here on these calls, that they don’t increase pricing right away. Their costs go up and then they respond. They don’t raise prices right away. There will be a several month lag that some say now I’m seeing costs, pricing power, things I really haven’t seen in a long time. The last time we had this type of environment, I think was probably 1999, where wages were growing 4% or 5% and the labor market was very tight. 

Preston Pysh  11:47  

Eric, a lot of the people that we talked to, they’re pretty bearish on the fundamentals just because of things like the PE ratio, the Shiller PE being the second highest it’s ever been in the history of the market. I’m assuming you share some of this bearish sentiment, but where would we be wrong as far as this thing could run a lot more and the reasons why?

Eric Cinnamond  12:07  

Yeah, I mean, we could definitely be wrong. I think back in the early 90s, when Home Depot was one of the most popular stocks, it was very expensive. A typical value investor wouldn’t touch it, but it never crashed. It sort of stayed in this channel for 10 years. I need a chart to verify that. 

What happened was earnings caught up with price over time, so it never crashed. Maybe that’s what happens in the cycle. Maybe for 5 to 10 years prices will stay in a narrow range and fundamentals catch up to valuation, to where that normalized earnings, a Shiller PE goes from low 30s to back to 60 or 70, just on earnings growth over time. That’s one of the risks. 

Maybe too the Federal Reserve eliminates the business cycle. It’s possible. I still believe the business cycle. If I think about all the variables of the companies I follow, what impacts their margins, they haven’t changed, right? 

Just look at the energy credit bust in 2015-2016. The credit got pulled away and the energy industry plummeted. The CAPEX plummeted, earnings plummeted, companies went bankrupt. 

If the variables and impact margins of industries haven’t changed, why should we expect the profit cycle and aggregate change? 

I’m still a believer. If I wasn’t, if I didn’t believe that the profit cycle was dead… I believe that valuations wouldn’t revert to the mean. I obviously wouldn’t be positioned how I am today.

Stig Brodersen  13:34  

Eric, you have this comment about inflation and the potential catalysts about how to change the inflation environment. Can you elaborate a bit more on that?

Eric Cinnamond  13:45  

Well, I go back to 2014. At that time, the middle of 2014, things were going very well and things were starting to tighten up. Obviously, that was back when we started exiting the QE3 discussion. We also got a bone from a very cold winter in Q1. 

The momentum was there. Earnings growth was there. Then the dollar spiked at the end of 2014, if I remember. Then the commodity stocks and commodity industries took a huge hit. The prices of the commodity prices took a huge hit. 

I believe that period we didn’t have a recession. It was close. We had a couple quarters of very low growth. It wasn’t negative, but we did have an earnings recession. We have five or six quarters of negative earnings. 

What happened there bought the cycle some time. It took a breather and then it also allowed the foreign central banks, the ECB, and the Bank of Japan to step in and decrease their quantitative easing.

Remember the ECB started to buy corporate bonds? That was a big deal. That just really boosts things up. Spreads tightened and then the energy industry was able to issue equity and debt again. 

Before you know it, things healed in the energy industry. I believe that was a big deal, because if we would go back to triangulating the companies, all different industries I follow, well, when did the energy bust hit? 

It wasn’t just the energy industry that was affected. That was a big credit generator, that energy industry. People were throwing credit at it and raising a lot of capital. That was spilling over into the economy. 

It was kind of like a mini housing boom, right? During the housing boom, it didn’t just stay in housing. It spilled over into the economy. The same thing happened with energy. All that credit and all that growth was spilling over into the broader economy. 

That went away for 2015-2016. We had sort of had that flat earnings growth, flat economy. It’s really not a very impressive stock market either for most until later 2016. 

So that all changed and now energy industries have turned from a headwind to a tailwind. When the energy bust hit, I was seeing companies report X-Texas. I have never seen that before. There’s this new non-debt. We’re going to report the results and we’re going to separate Texas from everything else. Now they don’t report X-Texas because it’s healthy. 

Anyway, so just restaurants and retail. We’ll go back to tracking, industrial cyclicals, steel, railroads. Alot of industries were influenced or impacted by the bust. It’s now the revival. 

Preston Pysh  16:25  

For me, the whole energy sector really feels a lot like 2007 getting into the 2008 timeframe, where we went on a really big bull market. It kind of feels like we’re at the start of that. Would you agree that things across the board kind of feel like that’s what’s happening here?

Eric Cinnamond  16:43  

Rig counts are up 30% year over year. CAPEX, though, I would say right now, it could change. But right now, it sees a little more discipline than $100 oil, early 2014. 

I’m a little reluctant to say we’re going to spike like we did then, but it’s possible. Anytime you have this industry capital, they go, I can’t remember a time when they stay disciplined for long. It’s just in their blood. They love production growth. They love it. A lot are compensated on that. Some of their comp models are based on production growth. That’s what they like to do. They are born to drill. 

Now the economics are just at 70. They’re pretty good. I was on one call. I think it was Patterson UTI. The CEO was saying, “We were growing at $50 oil. Things were coming back at $50. Now we’re at $70.”

So to your point, we couldn’t be back off to the races.

Preston Pysh  17:37  

We had a brief conversation with Jesse Felder on our Mastermind Discussion about gold. I’m kind of curious where you’re seeing gold miner stocks. Do you follow any gold miner stocks? I’m kind of curious to hear your thoughts on that stuff.

Eric Cinnamond  17:49  

Yeah, I was introduced to the mining sector in 2014 to 2015. We talked about the rising dollar and the collapse, and a lot of the energy names. The miners were devastated. As a value investor, that’s sort of where you start to look around when no one wants to own them.  

I go back to that period. It was very, very difficult to own and follow. However, I got to know the industry well, because there were so few places to find value. This was a little oasis of value. I’ve spent a ton of time on it, because there really wasn’t anything else to work on. 

When you’re in a patient position, when you have a considerable amount of your holdings, T-bills, there is this uneasiness of not owning anything tangible. That is a risk. 

Being patient is not risk free. You’re incurring tremendous opportunity costs. Obviously, you’re incurring risk, the loss of your purchasing power. I don’t like holding cash. I’d much rather have a fully invested portfolio with 70 cent dollars, high quality small cap businesses. 

So currently, I do like the idea of owning some minor. I don’t owe any now I’m getting through earnings season. There’s a couple I’m interested in maybe owning again. I sold the miners in the spring of 2016 or summer 2016. It was a very fortunate exit point there. They hadn’t rallied. In fact, some of them are down considerably from their peaks in the summer of 2016. So I do find some interesting where they’re trading below what I believe is a fair replacement cost for their assets.

Preston Pysh  19:27  

If you had to name one or two companies that you really like right now, what would those names be?

Eric Cinnamond  19:32  

The six month T-Bill just exceeded… I think it’s 2.05. Two years at 2.53. So if those were stocks, I think they would compete very well versus the S&P 500. Not only from a dividend yield perspective, but from a normalized free cash flow. They’re getting up there.

Preston Pysh  19:51  

Talk about this a little bit more for people. Explain exactly what you mean by that.

Eric Cinnamond  19:55  

Well, I’m saying if you normalize cash flows for the average company, the average stock market potential bias is a little over 30 times earnings. That’s not even normalized. Price to sales is 2.5 times, very expensive. 

The S&P normalized earnings I believe was around 32 times. Maybe you know this better than I do. So that’s the free cash flow yield, if you say earnings are free cash flow. That can be an assumption that maybe you could argue, but let’s just assume that. 

So your 3% free cash flow yield, all the earnings are paid out to you by the S&P 500 on a normalized basis. You receive a 3% coupon. But right now, you can buy a two year Treasury to almost accomplish that, risk free. So 2.5%  risk free or 3% with  margins normalized. That coupon gets cut in half and with rates up. The stocks really haven’t responded so far. I mean, the Russell 2000 is right at its record high right now.

Preston Pysh  20:53  

I think what’s interesting about you saying the two year, your risk, because it’s in such short duration on the price is so minuscule that you’re getting all of that so you don’t really have to worry about the resale value being impacted as if it was like a 15 or 30 year bond. I mean, the short end of the yield curve is coming up like a freaking rocket right now. 

Eric Cinnamond  21:21  

Looks like a FAANG stock.

Preston Pysh  21:22  

Yeah, it does. It’s crazy.

Eric Cinnamond  21:24  

I find it exciting. I was at a social event a few weeks ago. Everyone’s talking about their favorite stocks. I was like, have you seen that two year?

I find it exciting to just watch yields go up in the market, not pay attention. I mean, a few people are talking about the lower taxes,  going to 21%. But if you assume 100 to 200 basis point increase in your discount rate and say your discounting rate is maybe 5% or 6%. I don’t know what people are using now, but that would have to be a low rate. 

That takes all that away. From a valuation perspective, the valuation math, the higher discount rate takes completely away the tax rate benefit. Though all people talk about the tax rate benefit, not what’s happening with interest rates.

Preston Pysh  22:18  

You know what’s so funny, Eric, is we’re talking about 2.5% on the two year and after you account for 3%, inflation, your real return is a  -.5%. But you’re comparing it to cash, which is basically a -3% return. I mean, if we could just step back 20 years ago, and play this conversation…

Eric Cinnamond  22:44  

You’re right. In 1999, I talked about that’s the last time I remember the labor market being this tight. Short rates were at 5? I know that’s where they were in 2007.

Preston Pysh  22:56  

Yeah, right. They were like 5.5 a day. 

Eric Cinnamond  23:00  

I just read Q1 calls. I had no idea where interest rates were. I read these calls and I saw all the commentary on cost inflation wages, the labor market, install margins where they are, and top line growth. 

I would have to guess that we would be close to 5% or 6% on the short end because if my companies are raising prices, 3% to 5%, *inaudible* short rates are around that level. 

I mean, we’re at 1.5% to 1.75% on the Fed funds rate. You have clear evidence of companies raising prices, like this isn’t… The CPI last week came out .1 or something. I just shook my head and said, “This is incredible.”

Here you have corporate America telling it. They usually don’t tell us because pricing is a very sensitive topic. You really don’t want to broadcast. You might upset someone or you might show your hand your competitor. 

However, they are telling us on these calls. They’re actually saying, “Inflation is a problem. Yeah, this is how we’re going to address it.” 

Stig Brodersen  24:06  

Your commentary really reminds me of the interview that we did with Bill Miller here on the podcast. He said, “Looking where things are right now, this could be somewhere around the 5% range. Back in 2000, it was a Shiller PE of more than 40. Interest rates tripled back then. So why couldn’t it happen again?.”

I’m very curious to hear your thoughts about that, Eric.

Eric Cinnamond  24:32  

Because I think people will believe the system can’t handle it.The safety net for rates is they can’t grow that higher because it’d be a complete disaster. It was the same argument for housing.

Preston Pysh  24:47  

Just looking at the trend line of the 10-Year Treasury, you can see that it’s buttoned up against that 35-Year trend that we’ve been on. I don’t think anybody wants to see what happens when it breaks that trend, because I think that it’s going to be some interesting times in the markets if that actually materializes. 

I’m with you. If housing rates go up in any substantial kind of way, there is going to be some serious problems that happen across the country. I agree with you 100% on that.

Eric Cinnamond  25:20  

Long bonds are interesting, too. It’s hard to say what the bond market is communicating to us, because the Fed really hasn’t reduced the balance sheet considerably, right? So we still don’t know what the real rate is. It is still artificially suppressed. 

However, if we could gather information from the long end, I would speculate that telling us the short end is going to continue to rise. Though eventually, it causes an exit and the long end is going to be right, where we have another deflationary event. 

So I always say there’s inflation now, then I’m seeing it. It’s very clear to me, but I also say, if we have a financial accident and valuations revert, all bets are off, because then demand plummets. Then we’re back to that QE4 and QE 5 and then regroup. Let’s start again. But in that transition period, there will be a slowdown.

Stig Brodersen  26:13  

I think what the market is really surprised about is how fast this has changed. I mean, one year or two year. It’s just been taking off like a rocket.

Eric Cinnamond  26:26  

It’s almost as if the two year is running the show. It seems to be functioning. I like it. I’m not only getting paid more to hold these short term treasuries. But I like the fact that this feels like markets are functioning again, at least on the short end.

Preston Pysh  26:40  

I think it’s the QT that’s happening, the quantitative tightening.

Eric Cinnamond  26:44  

And the supply, maybe it’s just that basic demand supply, right? Maybe diminishing or  the central banks, the Fed, at least isn’t buying bonds. They’re selling them. Now we have fiscal deficits rising. We’re going to issue more debt.

Stig Brodersen  26:59  

I’m curious to hear how the Two-Year Treasury, if ever, would change your approach to how much and how you invest in small cap stocks, like we talked about before? Is this a macro narrative that is changing your portfolio strategy right now?

Eric Cinnamond  27:18  

For me, it’s valuation based so I can’t buy these companies. I’ve never used these risk free rates to value businesses. 

I think about what my required rate of return is as an investor. Historically that’s been 10% to 15% on small cap stocks. I’m thinking of it from a perspective as a credit analyst first, what do I require for this business, and then I want a risk premium to that. So that’s how I get my 10-15%. So that’s my required rate of return.

At today’s prices, there’s just no way to get that type of return to small caps, right? So for me, even though I have a good feel for the macro from my bottom up work, which does lead me to believe that rates are rising for a good reason. That would be negative for stocks, I’m not making a call on stocks. I’m a horrible market timer. 

I’m just saying, if I was fully invested and I was paying 30 times plus or normalized earnings, I would be very concerned with rates where they are because they are competing with you right now on a risk free basis. You are in a business with uncertain cash flow.

Preston Pysh  28:26  

So talk to us about valuation. Warren Buffett always mentions intrinsic value. How do you think through your valuation of a stock pick? Do you use discount cash flows, multiples, a combination of approaches?

Eric Cinnamond  28:39  

I use a discounted cash flow method. It’s a lot simpler than most. I talked about the discount rate of 10-15%. So that’s my required rate of return. That’s what I want on my equities. 

Over my career, from 1998 to 2016, that’s what I achieved on the equities. So people always say.. If you don’t use a benchmark, if you are an absolute return investor, what’s your hurdle rate or what do you compare yourself to? I say, ‘Well, the return I’m attempting to achieve, that’s my required return and that’s what I’m trying to achieve.”

So I use that 10-15% discount rate and then I use a cash flow assumption that I normalize… If you have a business over a cycle that generates 7% of EBIT margins on the trough and 13 on the peak, you kind of use a normalized margin to come up with a normalized cash flow. 

So 10-15%, required return normalized cash flow, and then a perpetual growth rate that is more in line with nominal GDP, because most of the companies I follow are very mature, they’re not growing 15-20% a year. Already in line with the economy companies.

Preston Pysh  29:41  

So you’re valuing them into perpetuity? You’re not just doing 10 years or anything like that?

Eric Cinnamond  29:46  

Yeah, because I have discovered over time… I tried this when I was younger, I thought I knew everything. But I thought I could actually predict what the cash flows of a company would be five years out. Well, I quickly learned that’s impossible.

So I said, “Let’s quit trying to guess each year.” Normalize the cycle, which then you can actually get a much more accurate valuation because you can be wrong and you’re three, but then maybe you’re right, and you’re seven. It all averages out. I found normalizing keeps me out of trouble on the upside and downside.

Preston Pysh  30:18  

What timeframe do you switch over to basically the inflation rate about 10 years or five years?

Eric Cinnamond  30:24  

No, I did it right away. I’m using almost like a professional bond valuation. It’s normalized cash flow over K minus G. So if I’m saying a 12% cap rate, which would include say, a 7% required return on the debt, 5% equity risk premium, and then I subtract a growth rate of 4%, then I’m capping that business’s cash flows at 8%, $10 million, on an effort was on 120 million valuation.

There’s a lot of work that goes into that normalized cash flow and then a lot of work that goes into that discount rate, because you need to know everything about that business to get a good feel for… Again, as a credit analyst, what you should require as a return and then as an equity analyst, or equity risk premium, what you should require for the added risk of owning the equity. 

It takes some suitable time getting another business and it’s why I like to follow the same companies, because I want a good feel for the businesses. It’s a lot easier for the fallen for 20 years because you have seen everything that they’ve done and what they said. They follow through with it in every cycle of the game. Sure, they lost here. You just see so much more. They get a higher degree of confidence in your valuation by sticking with more mature businesses.

Stig Brodersen  31:42  

Say that you’re seeing this company, and it has a declining or, say a stagnant top line. Well, that would probably also be one of the reasons why we price a very attractive multiple, and then you’re trying to base your valuation based on that. Talk to us about how you look at the importance of the top line.

Eric Cinnamond  32:02  

It’s extremely important. We talked about these rising costs and these pricing maneuvers by companies. 

Now, if you want to know the health of a company, you really need to be looking at volume, units sold, services sold, because price is a big part of it. There’s a lot of restaurants now with negative traffic trends, but they have positive comps, because their average ticket is up, 3-5%. That’s something that’s very important right now is the top line.

But the health of the top line, is it price or is it volume? It’s a big difference. That can be the difference between a healthy economic expansion and stagflation.

Preston Pysh  32:40  

Eric, I’m curious how you handle filtering and finding new companies that you’re adding into the mix? Is it just something that you kind of happen to find or is there a method that you’re using to filter these kinds of results?

Eric Cinnamond  32:54  

When I was running a fund, I used Bloomberg, their screens, and I don’t have standard screens that screen on market cap and profitability. I would try not to weed out too many companies, because, again, I normalized cash flows so I don’t mind if a company isn’t generating trough results. But that can knock out a lot of companies out of screens, because their earnings will be down and their valuations will look elevated. I try to avoid that by being inclusive as possible.

I would say most of my ideas have come through just general screening like that going through a long list of names, but as my personal bias has grown and sort of stabilized, I think more recently, or in the past few years, more of my new ideas have come from working in companies. 

When I do my due diligence, learning about their suppliers, competitors, customers, and sometimes I’ll bump into some of their public counterparts. This is interesting too. It just goes on my list.

There’ll be some industries, I thought I would never own like the call centers. I never thought I would own a call center. I wasn’t sure if they would be high quality businesses. 

New industries occasionally come on, but when I go through screens now, I haven’t done it for so long. I know why I don’t have it on my possible buyer list. It’s very rare that I come up with a new name. If I do, it’s usually maybe an IPO that doesn’t have a long enough operating history to include it on the possible list.

It doesn’t change. Usually maybe a name will go on once a month. The name will come off once a month. My whole goal there is just to continue to improve the quality of my opportunities

Stig Brodersen  34:30  

Of the sectors that you follow, where do you see the bull case and where do you see the bear case?

Eric Cinnamond  34:36  

Bullish would probably be commodities. I think energy has done fairly well and energy and on average continues to have quite a bit of debt on their balance sheets. Some of the service companies are better off but many of the MPs still have a little too much debt for me. 

I do like some of the precious metal miners. I plan to work on Alamos Gold, ALG. It’s a debt free, precious metal miner. They have two mines in Canada and one in Mexico. There are actually two mines in Mexico, but one that’s actually of value, the other one is almost full depletion. It has no debt, over 200 million in cash so it’s  an interesting potential buy idea that I plan on working on.

There are some I think, miners now trading below tangible book or that sort of replacement costs valuation and work on.

Preston Pysh  35:20  

Yeah, I’m looking at the top line on ALG and it’s got a nice steady growth to it.

Eric Cinnamond  35:26  

It’s really nice. The recent rise in gold is how they’ve also done an acquisition so that might be a little more.

The main thing is their top three mines are generating free cash flow. Often when people think about miners, they’re horrible businesses, right? That’s what we were taught, bt the good mine can actually generate cash and considerable cash over a cycle.

Once it’s paid off, the development part is the CAPEX heavy part. But once it’s developed, we are still on sustainable CAPEX. Once it’s developed, you can generate a good bit of cash. If it’s a long end asset and their average reserve life is over 12 years, you got 12 years of cash flow generation, considerable cash flow generation at these prices. 

You look at the energy industry, what’s an average well life? They go through well, pretty quickly and the reserves very quickly. Majority of the reserves, sometimes in a year. Well, a good mine, the Young-Davidson mine in Alamos is a 15-year mine. 

Even if prices decline and you’re not assuming financial risk, which you’re not seeing much, because they have no debt and over 200 million in cash, you can get through the cycle. 

With a lot of energy names, it’s a little harder. Not only with the financial risk, because many of them have debt, but the reserves are very short. You have to keep drilling every year to keep replacing those reserves in that production. With a mining company, those mines again last over a decade. 

Preston Pysh  36:49  

How about the sector that you’re bearish on?

Eric Cinnamond  36:53  

Great question. It’s so broad. Usually, it’s pretty easy.

Preston Pysh  36:57  

I think the last time you were on, we talked a little bit about the retail sector. It had gone through just total punishment. Most of it was just because everyone was scared to death of Amazon. I think the traffic in a lot of these malls is way down. How do you see retail today and kind of moving forward? 

Eric Cinnamond  37:16  

We talked about retail the last time we talked and I think we both thought that the sector had been beaten down considerably. I would agree with that. Really the easier comps over a year, that’s sort of to be expected. 

However, also you’ve had many creditors go bankrupt. That liquidation has worked itself through. Inventories are in fairly good shape. I’m not sure I’m very enthusiastic about a lot of the valuations in retail. 

I do believe the operating environment is in the process of healing and improving. I think you’re gonna see more examples of full price sales, because inventories are in better shape. 

There’s more companies getting comfortable with leaving that sort of promotional mindset, which I thought we saw a lot of in 2015-2016, where emotions were running very aggressively. I’m seeing that die down, which is going to help count in profitability. 

Preston Pysh  38:12  

Well, the last question I have for you, Eric, is just who do you stalk on Twitter? Who is a person you pay a lot of attention to? It can be multiple people that you really get a lot of value out of their comments or what they’re posting or what they’re writing about.

Eric Cinnamond  38:29  

I’m not on Twitter. I’m actually talking with our friend Jesse Felder about this, because I know he’s pretty active on it. He gets a lot of value out of it. 

Right now, with my opportunity to set the size that it is, I’ve even considered narrowing it down maybe to 200 names. Most of my time is spent on trying to keep up with the companies I follow. 

I just haven’t had the time to get on Twitter and follow some of the brightest minds on Wall Street so that might be a disadvantage for me. That might be an advantage, too. 

Early in my career, I read more books, but as my opportunities grew, my *inaudible* grew. Then I started to find my own way. I remember when I first started the industry. I would be interested in what Mario Gabelli owns like Third Avenue. I would kind of pick through their names. 

Over time, however, I learned they make mistakes, too. Why not just know your opportunity set better than most. Let’s face it, some of the best managers that run billions and billions, they can’t do that by themselves. They have a team of analysts and you might cherry-pick off a 24 year analyst who just got out of grad school. 

You got to be a little careful there because there’s this false sense of security that if a great firm owns it, a ton of work has been done, and maybe it has. 

Knowing the names well allows you to act more decisively when those opportunities do appear. You don’t freeze, because, “Hey, I know this company.” Having followed it for 10, 15, 20 years, I’m so confident about its valuation. I’m so glad the stocks where it is now I can buy. There’s just no second guessing because you’ve done the work.

Preston Pysh  40:13  

Well, Eric, I’m sure there’s a lot of people out there listening that want to read some of your reports that you’re doing on all these different companies and just learn a little bit more about you. If they want to learn more, where should they go?

Eric Cinnamond  40:25  

I run a blog. It’s free and it’s EricCinnamond.com. It’s pretty easy to find. You can subscribe if you like. I plan to keep writing until I don’t want to.

Preston Pysh  40:36  

Well, we’ll have a link to that in the show notes. I highly encourage you to go there. Check this out. You won’t even believe the quality and quantity of Eric’s writing. It is totally awesome. Guys, make sure you go there and check that out in our show notes. 

Eric, thank you so much for joining us.

Stig Brodersen  40:55  

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

Outro  41:02  

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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