Preston Pysh  1:19  

So I love these episodes because we’re always talking about the big companies. But there’s tons and tons of great small-cap businesses that you can find out there. And there’s tons of them. It’s just hard to know the specifics. And they kind of get bumped around a little bit more in the marketplace because they are competing with big contenders and mid-cap and large-cap. So I’m excited to talk to you about a couple of companies that have piqued your interest. 

Also, we want to go a little deep into just a couple companies [as] opposed to just talking about the broad industry and just talking general information. So, let’s dig into some things. Let’s show some people how you do your analysis. Let’s hear it. So like what would be one of your first picks that you would want to talk about, Eric?

Eric Cinnamond  2:04  

Well, I’ve got one that just the name of it’s going to turn a lot of people off. It’s called Natural Gas Services (NGS). What they do is they manufacture and lease natural gas compressors, so it’s a pretty exciting business. It’s about $170 million market cap, so probably it’s not going to make it on a lot of your screens. And right now, they’re near the trough of the cycle, so they’re not making a lot of money. So if you screen on income, you know, net earnings, you’re probably going to miss this type of stock.

Preston Pysh  2:29  

Yeah, and that was one of the first things, so before we started recording, Eric sent over the three tickers that he was going to discuss. And so, when I was just looking through the financials on this one, that is exactly what stuck out to me, was the net income for 2018 for the last year was literally nothing. But the years before, you were doing $20 million, $6 million, $10 million, $14 million, so it’s knocking out anywhere from like $10-20 million a year. And then, the top line on the company for 2018 was $65 million. So, talk to us why you’re thinking right now is a great time versus any other time.

Eric Cinnamond  3:06  

Well, it’s a natural gas compressor company, so it’s tied to the NPS, you know, the energy industry. And obviously, extremely cyclical. So I always liked to buy cyclicals near the troughs. And this definitely applies for Natural Gas Services, where, you know, natural gas exploration is, you know, in the tank right now. It’s probably going to get worse, when natural gas near $2. The business also is used for oil. 

So just overall, the industry is becoming much more disciplined with CapEx. You know, you see a declining rig count right now. Really says 2014 energy service has been, you know, pretty much in a bear market with near trough results. In this case, Natural Gas Services is almost an asset valuation, you know? We usually the way we run money is we usually value businesses, this kind of future free cash flows, and I know you guys do a lot of that as well. 

That’s where that perpetual bond and the high quality business, where Natural Gas Services at this point, the assets are very inexpensive relative to any type of replacement costs, or even the market value of their assets. So this would be more of an asset valuation, where you can buy, you know, do we have a market cap of $170 million. And they have total assets of $300 million, and only $40 million in liabilities. $30 million of that is deferred taxes. No long-term liabilities. 

So you really only have about, maybe a little $10-15 million of true liabilities there that might be doing in the near term with $300 million assets, tangible book value, near $19 a share. Also, the stocks at $13. So a significant discount. The tangible book is 0.7. This is the cheapest the stock has been, since the crisis of 2009. So this is a good example of a net asset valuation, instead of a discounted cash flow valuation.

Stig Brodersen  4:49  

So Eric, whenever you say we are the trough of the cycle, how do you identify that?

Eric Cinnamond  4:53  

Well, you can look at historical recounts that usually give you a good indicator of where you’re on the cycle, and right now, we’re very low in the rig counts. I would say it could go lower just the way the industry and energy industry has become more disciplined with their CapEx and cash flows. This is the first time I can remember my career. I’ve been doing this quite a while with energy, where they are living within their cash flows. And if prices of natural gas and oil continue to fall, I think you could see lower CapEx. 

But Natural Gas Services is an interesting situation, where their compressors, which by the way are used to increase the productivity wells; increase productivity. The compressors are also used to transport the gas from the wells to the midstream assets are the pipelines, again, very tied to the CapEx of the energy industry. So overall, it could go lower for sure. But that’s why you want to have a sort of energy service coming to a very strong balance sheet, which they do, you know, they have $70 million in networking capital, $30 million in cash. 

It’s very rare that you see an energy firm that focuses on full cycle profitability. They’ve done a good job history. We only invest when they’re getting paid to take a risk, and they’ll do it aggressively with their cash. And then, when they’re not getting paid, they won’t [invest]. 

It reminds me a lot of how we manage money. You’re getting paid to take risks. You should [get paid]. And when you’re not, you don’t [invest]. And that’s why you’ll see their cash actually fluctuate on the balance sheet, considerably. You know, it’s been as high as over $60 million as low as near nothing, but they’re not going into debt. You know, it’s very important that you have a strong balance sheet name. 

So to answer your question, it could go lower. But if it does go lower, you want to own a cyclical that has a good balance sheet, where the competitors, most of the competitors and some of our LPs, they pay dividends. Their cash flows are constrained. Their balance sheets are much more levered. Many of their competitors [are] highly levered. That’s a competitive advantage. 

And I think as we go through this cycle, what we’ll find, I think, especially when it ends, the balance sheets are going to really become important. The three names we’re going to talk about all have great balance sheets, and I think that’s the theme we’re focusing on right now.

Preston Pysh  6:53  

So you’re saying that because NGS doesn’t have that model, where they’re having to pay out these very large dividends, it gives them a lot more flexibility in the way that they can invest and prepare themselves for risk-on, risk-off type behaviors. Is that, am I hearing you right or is there something more to it?

Eric Cinnamond  7:07  

No, that’s exactly right. I mean, a strong balance sheet is a competitive advantage, especially for a cyclical business. I mean, the last thing you want to do as an owner of…or if you’re running these compressors, and by the way, they do rent. Most of the revenues are for rentals. 75%, and the other quarter is the sales of the compressors, so it’s actually a pretty good business. You know, the rental gross margins are very impressive. But yeah, they will get some large pockets because of their balance sheet.

Stig Brodersen  7:34  

Let’s go into little more detail in the industry itself. What are you seeing right now?

Eric Cinnamond  7:40  

The low prices, you know, natural gas right now is near $2 FCF, which is very low. Well below breakeven for a lot of companies. There’s so much production, especially with the Permian and the oil related areas, where natural gas is a byproduct. You can’t give it away. The only thing worse than natural gas right now, I think it’s toxic waste. You had to pay money to pull it out. You could flare it. You can only flare it for so long. You get a license for that. 

So yeah, you should probably pay attention to the cycle, [a.k.a.] the energy cycle. But what I like about the energy cycle because of the shale wells, the lives are so short that the cycles are relatively compressed. If these wells in either lives are 12 to 18 months or the majority of the lives you need to replace these reserves are about 25% a year. $2 natural gas, I think is going to go a long way in solving the natural gas glut. 

And I know it’s called a glut, but if you look at the 5-year average inventory, it’s not that bad. And if you look at demand, it’s been growing quite a bit. You have the coal displacement. You’ve got exports to Mexico, more coal displacement, and some nuclear displacement coming up. So, natural gas demand has been growing about 3% a year, and that doesn’t include the liquid natural gas. That’s where we’re going to be exporting and have been [exporting]. 

And that’s probably going to double in the next couple years as well. So overall, I’m not too bearish on natural gas. But it’s just, it’s *inaudible* contrarian right now to own anything related to natural gas and/or Natural Gas Services (NGS) actually has it in its name, which probably creates a 20-30% discount alone. 

Preston Pysh  9:08  

Yeah, they need to rebrand it. I’m kind of curious if you are…when you talk about sizing for this, is this something that you’re kind of dipping your toe in the water to try to ease into it? Or do you think that you’re at a very good buy point, where you should probably be accumulating quite a bit of the stock?

Eric Cinnamond  9:26  

We could probably only discuss what we’ve owned on June 30. That’s our last disclosure. We owned a small weight at that time, but as the discount grows, you know, historically, we do add to the position. And we initially bought it, the discount was relatively small, but it has increased since then. 

That’s something we like to do over time as long as it has a good balance sheet and the valuation hasn’t changed. In this case, it’s just really starting. And the tangible book, you know, remains steady. Actually, it grew slightly. What’s really interesting about these cyclicals is they aren’t normally what we own. That’s just to be clear. 

Normally, we own that perpetual bond, that steady Eddie. But this is the environment we’re in, where these steady Eddies are so expensive. People are using cap rates that are extremely low to value these high quality franchise businesses. So here we are in these oddball companies that they don’t show up well on screens, you know? 

But if you look at this thing, and you look back 10 years, the tangible book was around $10 in 2008. And now, it’s around $19. It’s a nice compounder on tangible book, and I know a lot of value investors look at that. They always want these compounders, but you can compound in the cyclical nature. 

It’ll still go from $10 tangible book to $19 tangible book, and still it’ll be nice. A 6-7% annually tangible growth and book value, but it’s just *inaudible*. Again, it’s another asset heavy compounder with a great balance sheet. So, if you go into a meeting right now, and you want to talk to a…or consult a large client, and they ask you what you like, and you just say Natural Gas Services. It’s not good for business. 

But just remember the miners. Remember the last time we talk? Same thing, you know? The career risk you take on for owning these things. And I think Natural Gas Services applies. Anyone buying this right now is going to take on quite a bit of career risk because everyone knows natural gas is a bad business. 

Stig Brodersen  11:09  

If you’re going to be successful in the market, you have to have the courage to invest in stocks that are very unpopular, and you have to be right. So let’s talk about the next stock pick, Gencor Industries. The stock ticker is GENC. Please tell us what they do, and why this stock is on your radar. 

Eric Cinnamond  11:27  

Well, they are a market leader. They share market leader status with Astec Industries, A-S-T-E-C. They’re a market leader in asphalt plant equipment. Their business is highly tied to highway road construction. Government spending on those areas, and the certainty of that spending over time. Really 2009, 2014, there was a bill that provided certainty. And then, the FAST Act came in, and I believe nationally, I believe that was 2015, and that expired September of 2020. That created certainty for the industry. Same for Gencor went from $40 million to $100 million, so they spiked. And that’s actually, earnings looked very good over that period. Extremely cyclical business, but again, depends on the certainty of highway funding. We approach the end of the FAST Act, which you’re going to find is uncertainty for funding for highway spending. And I think you’re seeing it right now. 

Their backlog is declining. The earnings are declining, and their revenues *inaudible* are going to be declining pretty hard in the next couple quarters. But it gets $170 million market cap, $160 million total assets $150 million of those are current assets, $111 million of that is cash and marketable securities, [which make for an] extremely liquid balance sheet. Also, they have 27 acres in Orlando, owned, free, and clear in your downtown Orlando. So, there’s under valuation in real estate as well. 

Preston Pysh  12:45  

I mean, your comment about the current assets is somewhat mind blowing. So explain for people that are new to finance or maybe don’t understand the magnitude of what you just said. Explain that to them. $150 million of the total there. I think it was like $160 million or something. It was very close to the current number of assets.

Eric Cinnamond  13:06  

Yeah, that’s right. 

Preston Pysh  13:07  

Explain to people what that means. 

Eric Cinnamond  13:09  

So the $162 million of assets, so you’re buying the business for $175 million, then it has $162 million of assets, and $154 million is current assets. $111 million of that is actually liquid in cash and marketable securities. That’s an interesting story, how they got their cash. They built two synthetic plants for carbotronics. This was a long time ago. Part of the payment, it wasn’t just in cash. They gave them ownership of two of these plants, and they got massive tax credits for these. And eventually, large cash payment. 

I mean, they got a ton of cash, and it is invested in corporate bonds and equities as well, so you should know that. There’s some market risk there. But what this is saying is the business is extremely liquid, even though it’s cyclical, and they do lose money in downturns. It’s not significant relative to the cash. And again, it’s a competitive advantage. 

So when you value things on book value, they’re not all created equally. And that’s one of the things with Natural Gas Services as well. What you have is with Gencor, a book value of $150 million. What most of it is assets, right? So it’s like $160 million in assets and $10 million liabilities. I mean, that’s really incredible, where you don’t have the risk and the liabilities. And usually, when people look at book value, they’re just thinking of their assets. But there’s also liability risk.

Preston Pysh  14:23  

Well, I think it’s important that if a particular company like this is being traded heavily based off of the book value, and you have all those risks on the balance sheet, and now, all of the sudden, the valuation gets really elastic. I guess I’m just adding a little bit more context to your comment because it makes so much sense after you describe it that way. And I think that there’s a huge learning point there for a lot of people [in] that if you are using the balance sheet or the book value to help measure value, or you’re using that as your multiple, think about what he just described because that’s a huge tip.

Eric Cinnamond  14:56  

Yeah, and another thing I would recommend, and again, these are all court, sort of tangible book valuations. Look over a long period of time and through all their cycles. Also, look for the write offs because you can have a large tangible book, which in this case, we have with NGS. Not so much with Gencore, but it’s much more liquid. 

We could talk about that as far as the discount goes. But if you go back to Natural Gas Services look historically after the crash in the energy industry, and then you look for the write offs. And actually in 2014, it was a very nasty environment. They had a tiny right off. It was $900,000 net. Very insignificant relative to $300 million. 

However, if you look at a lot of energy companies, yes, you could find plenty that discounts the book. On the other hand, if you look historically at them over a long period of time, especially the EMP companies, you’ll find multimillion dollar, hundred million dollars of write offs.

Stig Brodersen  15:45  

That’s very interesting, Eric, and in continuation of this, what is the big risk factor for Gencore industries? Where could you be wrong in your assessment?

Eric Cinnamond  15:54  

The allocation of the $111 million in cash, so it’s a good thing and a bad thing. But historically, you know, they’ve held on to this. And I think they could do an acquisition in the future. But I think they’ve done a good job of waiting, and obviously they waited a very long time, so that gives me comfort. But that would be a very big risk, where they did an acquisition because extremely cyclical companies don’t like being cyclical, you know? And they might do something with that cash to try to change who they are, you know? 

I like the embrace. Hey, we’re a $40-million to $100-million revenue company, depending on where we are in the cycle. Normalize it, and you could come up with $4 million or so of free cash flow yearly. It’s not a bad business. But if you go buy something completely different, you could completely alter this business. So that’s going to be the tricky part of them.

Preston Pysh  16:37  

Interesting. Okay, well, let’s go ahead and try this last one here, the Crimson Wine Group. And this is a ticker: CWGL.

Eric Cinnamond  16:47  

It’s the same market cap. It’s funny all three of these are $170 million. It fits with our view on small-caps right now. Where you’re finding value is away from the professional bond high quality names. Everyone’s own franchise right now and wide moat. Those are very expensive in our opinion. It goes back to owning the good balance sheets, but also the smaller market caps. 

We’re trying to veer away from the small-cap crowds and ETFs in the crowd of mutual funds. So, this is another one, [which is] extremely under followed. They don’t even do a press release, when they announce earnings. It’s called a Trypsin Wine Group. The symbol is CWGL. 

Again, very underfollowed. [They’re] a $170 million market cap, $211 million in stockholders equit, and they’re a winery. In addition, we believe their acreage, specifically their Napa acreage is undervalued because the…it’s on the book of costs. They started building these assets in the early 90s, so this is a neat one. And if you’re in a period of unlimited quantitative easing, and you want a hard asset, this stuff might be for you.

Preston Pysh  17:49  

I like that. I’m looking at the income statement. So you talked a lot about the balance sheet, and you talked about why you think that the balance sheet is not reflective of reality. When we do look at the income statement, in 2018, the top line was $68 million; the bottom line was $2 million. And so, we’re looking at a very low margin kind of business. I mean, around like 3% kind of margins. Is that normal for the wine industry? I’m not an expert in the wine industry for companies of this size. Is that pretty normal?

Eric Cinnamond  18:21  

It’s all over the place. Some of them like constellation brands. [They] have pretty high margins. They do ultra high-end wine, so their margins are all over the place, too. Actually, their gross margins. What you have is a certain wine harvest. 

They use a third of their wines in the Napa Valley for their own wine, but then they also buy two thirds of their wine…grapes. So a great harvest or *inaudible* week, which we’ve had over the past three years. 

Great prices will increase, and the margins will come down. So actually, last year is a pretty rough year. This is clearly an acreage valuation, where you are valuing the acreage of the winery or the vineyards, then we’ll take each of the properties of *inaudible* per acre value and get to value other acreage. 

And then, we value the inventory, which is very high in valued assets or the winers. And Crimson doesn’t have necessarily high operating margins over cycle. They tell us to buy these high hourly companies and high margin companies. High profitability, but low return on capital businesses aren’t always bad investments because you are not the one paying the capital price. That some capital someone else paid for that, whether it was reinvested by the company or someone else maybe bought the IPO, but that capital was formed in another way. You are paying the market value. 

So, if I can buy something like a .7 times valuation, that’s what I’m paying. I’m not paying full price for that capital. Very important to look at the price you’re paying for these businesses, not necessarily just what the returns are on the balance sheet of the particular capital that you didn’t put up. I love when people put up a lot of capital, and you can pay a nice discount to that capital and get to use it.

Stig Brodersen  20:00  

Do you know if there are many buyers for the land? And the reason why I’m asking is that we are paying an opportunity cost for tying up our money into this investment. Also, we don’t want to be stuck with valuable land that no one appreciates, so we would need a catalyst to drive the valuation. How do you see value being realized by the market?

Eric Cinnamond  20:20  

They’re very stable. It’s very interesting. In the 2008-2009 Crash, they actually held up, and they didn’t decline. But if you put that against like the San Francisco property values, residence for real estate, and not correlated at all, I mean, those collapsed. 

So the answer to your question, it’s possible. There’s not a lot of people to sell to, but that’s kind of a good thing, when say, this “everything bubble” pops. Historically, this doesn’t mean it will happen in the future. But historically, they’ve held up well and appreciated well. There’s only about 47,000 acres or at least 45,000 acres of Napa Valley acreage in California. But again, you’re not going to get there on the income statement.

Preston Pysh  20:57  

So on this one in particular, when you look at the price movement, since the middle of 2017. It has been in a steady decline, and a decline that when you look at the volatility, the standard volatility that you would see in the company over an annualized basis, it appears that the volatility that we’ve seen since 2017, as it’s been going down, has been pretty standard. It doesn’t look like the price is broken out or kind of demonstrated that something has changed. So is this one that you just kind of put on the shelf till you do see a breakout in that volatility range?

Eric Cinnamond  21:32  

Yeah, this is one that…and that’s why we became interested in the idea. Jamie found it really because it had been declining for so long. We’ve been doing these screens on asset heavy companies. This one showed up. It’s another $211 million in stockholders equity. We believe it is undervalued, and it showed up at a nice discount. So yeah, these are sleepy ones. 

I don’t think anyone knows. When they announce, they don’t do a press release. It’s very sleepy. Boring is often good. And that’s really what we’re looking for right now: high quality assets we can buy at a discount. And yeah, we’ll just put them in the portfolio, and let them sit. Let them mature. I’ve had these before where you wake up one day and something happens, but you don’t know when that day will be.

Preston Pysh  22:11  

Yeah, it’s kind of surprising to me. So I just looked it up on our TIP Finance momentum tool, we can see what the annual volatility is for the company. And for a business of this size, small cap business, the annual volatility is only 13% on this company, which I think is very low and not characteristic. 

I was expecting it to be way higher than that. Just something interesting to think about, considering that it is a small business. And if you get into something, and it has very high volatility and you’re wrong, it can sometimes be a very painful experience because you can see operating inside of that range. You don’t know if it’s broken out or not, so…

Eric Cinnamond  22:49  

Another thing with these smaller ones and these asset heavy companies, you know, we talked about the competitors having a lot of debt, and the reason for that, you can borrow using these properties; these assets as collateral. So it’s very rare to find these types of asset heavy companies without debt, again, because of the ease and borrowing. 

And so, I find that very refreshing. There are other ones out there that I could find at a discounted book, but they have a lot of debt. There are farm rates. I was interested in a farm I was looking at recently, but it had too much debt. So going back to the current assets, they have $107 million in current assets and only $7 million in current liabilities. So, again, very few liabilities. It’s just hard to get the liabilities wrong or [there are] just not [that] many of them, and quite a bit of liquidity. It’s very rare to find hard asset companies with clean balance sheet and no debt.

Preston Pysh  23:35  

Yeah, I’m looking at our tool. We have a thing called a “mini balance sheet.” And for the assets on this company, it’s $10 and $.67 cents per share, compared to $1 and $.75 cents for liability. And I mean, that’s just huge.

Eric Cinnamond  23:50  

Yeah, it’s incredible. It’s a…and you know, insiders own 22%. They’re actually spun out with Lucadia in 2013. They didn’t really fit, so you have insiders consistently buying not a lot, but just a little bit, and [they] never sold a stock. So yeah, this is a sleeper, and probably won’t do anything. It’ll probably drip and go down and bother us, and we’ll probably buy more.

Stig Brodersen  24:13  

So this is my question for you. You listen to a ton of earnings calls for small-cap companies; always looking for the next stock pick. What is the common theme you learn from this latest earning season?

Eric Cinnamond  24:25  

I’m finding now that the stock market and the economy seem to be highly correlated, which I don’t think should surprise anyone at this point of the cycle. And then, Q2 wasn’t recessionary, you know? I think a lot of bears, and I’d put myself in that camp. The cash in the portfolio is about 92%, I think in June, so extremely high cash level. So I would consider that bearish, where the consumers’ sector seems to be doing quite well right now, but there’s definitely more uncertainty in the more cyclical names such as transportation. 

Energy is definitely slowing. I think we’re having a week Q3, Q4, and so the industrials as well. Obviously with export concerns, so it’s definitely a more mixed picture. But I don’t see it as an environment where we need to be panicking at this point. All bets are off. We are [expecting] a 20-30% decline in asset prices. 

Preston Pysh  25:12  

How does the bond market play into some of the ways that you’re looking at where we’re at in the entire business cycle? Because I mean, you look around the world, and you got all these negative interest rate bonds, especially over in Europe. The US is the best in the world right now as far as getting any kind of yield. Do you have concerns of some of that spilling into the impacts to some of your positions in the small-cap sector? 

Eric Cinnamond  25:36  

We don’t use sovereign debt or yields or risk-free rates for our valuation purposes. When we discount future free cash flows, we’re typically using what we’ve lent to a business and apply risk premium to that, because, in our opinion, risk-free rates have nothing to do with the risk of the cash flows of a business or very little to do [with] *inaudible* what happens to the economy or the result from the economy of those low rates, so it hasn’t influenced our valuation process.

However, I would say, it’s definitely made my head hurt. And then, when they have negative rates here, of course, it’s coming. That’s what I’m being told. I was listening to a manager on Bloomberg TV last night explain why sovereign debt should yield zero or less because there’s no risk. But I said, here’s a fiduciary on television, already explaining people. [He’s] really justifying how you can own these things. It’s concerning.

Stig Brodersen  26:25  

Yeah, you hear that argument about having no risk, and as long as you don’t have a competitor to a fear-based currency system with a fixed monetary baseline to some extent, one could make the argument that this rake could continue for a little while. Even though I don’t think that “risk-free” is the right term, perhaps “rude awakening” might be the term we’re looking for here.

Eric Cinnamond  26:46  

Rude awakening with some very uncomfortable client meetings, when they have to explain how they bought a 30-year debt with a negative yield. I’m glad I’m not going to be in that meeting. I hope it doesn’t come here. But I guess that’s the new narrative, right? 

They’re already building it. That it’s okay and justified, and this goes back to the operating results of the companies. [The] labor market is still pretty tight. Economy’s not that bad. It will be if the market crashes, for sure. That definitely will be a very nasty recession. But as it is right now, while these decisions are being made, things are not that bad to even be contemplating these types of rates and these types of policy measures. It’s very concerning. 

Preston Pysh  27:23  

Crazy. 

Eric Cinnamond  27:24  

Yeah, yeah, to say the least.

Preston Pysh  27:26  

Well, Eric, I’ll tell you what, we just love having you on. You’re a breath of fresh air because you are down in the smaller businesses and just doing business the way business should be done. And I love it. So thank you so much for coming on and talking about these three companies.

I’m sure people who were hearing how you described this and how you’re coming up with your valuations learned a ton. We’d love to have you back anytime. So if people want to learn more about you, do you have a blog or anything that you’d like to hand them off to?

Eric Cinnamond  27:54  

Yeah, well, we launched Palm Valley Capital. We got a phone now. It started in April. Palmvalleycapital.com, you can you can look us up. We got a blog there. Yeah, check us out.

Preston Pysh  28:03  

Fantastic. We’ll have a link for folks that are listening to check that out. And thanks again for coming on the show.

Eric Cinnamond  28:09  

Thanks, guys! Appreciate you having me again.

Stig Brodersen  28:12  

All right, so this time in the show, we play a question from the audience. And this question comes from Adrian.

Adrian  28:18  

Hi, guys! My name is Adrian, and I’m from Virginia. Thanks for all the information you provide to your listeners. I really appreciate it. My question is about position sizing. How do you determine how much to invest in one position over another? 

Do you ask yourself, “Is it worth to put say, 10% towards this pick for an 8-10% return versus 5% of another pick for a possible 20% return, but [which] may include a bumpy ride with some additional risk?” Or are you determining sizing based on industry and economy at that moment in time or some sort of blended approach? Thanks, guys. I can’t wait to hear back.

Stig Brodersen  28:54  

Thank you for your question, Adrian. Ray Dalio famously said that having “15 uncorrelated assets is the holy grail of investing.” So really what you said about an idea of the risk and reward of various sectors and asset classes, I think that is important to have. But I also have the gun principle that I don’t know, which is also why I would like to be diversified. 

So, one thing is that we can talk about position size in the stock market. I think that’s very important. And I would say that I have a relatively concentrated portfolio. But the only reason why I have a concentrated portfolio is also because I have other assets that are not stocks, and they are uncorrelated with the stock market. I also have a private business. I own real estate and few other assets. Those really also influence how diversified you need to be in the stock market. 

Another thing that you bring up is the expected return. And yes, I do look at what the risk is of losing my invested amount, when I make my position size. I can handle a lot of volatility, but if I do think there’s a risk of losing a principal, but have a high offside that justifies it, I would definitely ensure to make many small bets, and mitigate the downside risk in aggregate, and then combine it with the upside. But really, there are as many ways to construct your portfolio as there are investors. 

If you look away from ETF investing, which is different, and you only focus on individual picks, I would suggest that you have between 10 and 20 stocks. With more than 20 stocks, the gain of extra diversification from owning another say, 100 stocks is almost non-existent as long as the 20 stocks that you have are already diversified. And you will likely be stressed out more about having 20 stocks in your portfolio, and even more on the watch list. It’s probably not worth your time. 

You can of course also choose to buy an ETF and the ETFs that investors typically buy is a market weighted ETF, meaning that the bigger companies are all represented. So, for instance in the S&P 500, Apple might be 4%. If you buy the biggest and most diversified, its apps, it might even be an equal weighted ETF, and you buy the stock market. You would typically not need more than 2 3D apps. And depending on your strategy, you might argue that you can just buy one ETF. You have ETFs out there that covers all asset classes. It has a very, very little volatility. I recommend that you do not have more than 10% of your portfolio in one security. 

And this is only in securities, where you think that the long-term risk of a permanent loss is close to zero. As certain as you might be that the investment thesis is correct. You could be wrong like Fisher said here on the recent episode, “Even the best investors in the world are only right 70% of the time,” so definitely always think about what Dalio has said about having 15 uncorrelated assets, and why that is so important in investing.

Preston Pysh  31:52  

So this is such a very important question because if you talk to anybody that’s managed money; that’s been in the game for multiple decades, they’ll be sure to tell you that it’s all about position size. So what’s incredible is you not only have to find winners, but you have to find winners that aren’t correlated according to Ray Dalio, who is one of the best investors ever. 

And so, I would like to share a tool with you that I found online that has helped me, and it helps you compare, and contrast, and understand the correlations between various stock picks and also various ETFs, and the tool is called aistockcharts.com. We’ll have a link to that in the show notes if you want to check it out. 

It’s great because you can put in whatever picks you have, whatever the tickers are, and it’ll show you how correlated the picks are. So, if you have a portfolio of 10 or 15 stocks, and you want to see how correlated they are, you can use this tool to figure that out. It’s very useful, and I think you’ll get a lot of value out of it. 

Of all the stock conversations I’ve had with people through the years, it’s very, very rare that you talk to somebody, and they talk about how they aren’t investing in something, or that they are investing in something because of the correlation between the picks. But I think that if you talk to somebody who’s managing an enormous amount of money, this is where they really focus their efforts. They try to find those winners, and they try to understand the correlation between them because that helps them mitigate their risk. 

So Adrian, for asking such a great question, we have an online course called our Intrinsic Value Course that we’re going to give you completely for free. Additionally, we have a filtering and momentum tool which we call, TIP Finance. We’re going to give you a year-long subscription to TIP Finance completely for free. 

Leave us a question at asktheinvestors.com. That’s asktheinvestors.com. If you’re interested in these tools, simply go to our website, theinvestorspodcast.com, and you can see right there in our top level navigation, there are links to TIP Finance, and also the TIP Academy, where you’d find the Intrinsic Value Course. 

Stig Brodersen  33:57  

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

Outro 34:04  

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