We Study Billionaires - The Investor’s Podcast Network - TIP194: Small Cap Investing & Intrinsic Value Calculations w/ Eric Cinnamond (Investing Podcast)

Starting point is 00:00:00 You're listening to TIP. Hey, how's everyone doing out there? So on today's show, we bring you the master of small cap investing, Mr. Eric Cinnamon. Eric has been an investor for two and a half decades, and his approach is very different than 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 10 ques of businesses under a billion dollars. Eric is listening to over 100 conference calls per quarter, and he stays totally immersed in the part of the economy where the rubber meets the road.

Starting point is 00:00:33 So during today's show, we talked to Eric about the common themes he's hearing on the quarterly meetings, and we also talk 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 sentiment. You are listening to The Investors Podcast, where 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. All right. So, welcome to the show, Eric Cinnamon, always awesome to have you. We were really

Starting point is 00:01:22 looking forward to recording this one. Thanks, Preston. Thanks again for having me back. I really appreciate that. Yeah, it's great to have you here. So the last time you were on the show, you had briefly mentioned your typical day of conducting research. And 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 how diligent you are because I've read some of your reports that you send out and it is absolutely mind-blowing the amount of research you do and how much attention to detail you pay for so many companies. So talk us through the quarterly calls. Tell us about the volume, like the number of calls that you listen to and just kind of walk us through your day of research. Yeah, I guess it depends where you are on the quarter.

Starting point is 00:02:07 a lot of time lately I've been doing maintenance research which is going through a lot of these quarterly conference calls and earnings reports so uh you know that takes about six weeks to get through about 200 calls I follow 300 names but they're on different fiscal years you know some of them so about 200 calls it takes you know I can get through maybe 20 a day sometimes you know it's a lot of reading but fortunately you know these are smaller cap companies they're a little easier to understand and their calls are you know there's still about an hour but the businesses themselves, it's a little easier than, say, trying to figure out General Electric, you know, back in the heyday.

Starting point is 00:02:43 You know, you're listening to so many calls, and I don't know anybody that listens to this volume of calls. And so, when you say you're listening that many calls, can you pick up immediately if there's problems in a business because you're listening to so many calls? Well, I should mention, you know, I read most of them. So a lot of it's transcripts. But it is important at times, you know, when I was running the portfolio, my top holdings, I would tend to listen to those.

Starting point is 00:03:08 I think tone is important when you're really trying to understand what management is trying to communicate. But, you know, the routine, again, is 10, 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. You know, I'm really trying to get a feel for where they are in their profit cycle. You know, what are the variables that are currently impacting their free cash flows in helping me better understand the business? helping you better value the business. Do you feel like you have a better idea of how a certain industry is moving because

Starting point is 00:03:43 you listen to these different calls? Yeah, and then you get a better feel for their suppliers, their customers, you know, the vendors, and what is influencing, you know, again, their margins at the time. You just think about right now the trucking industry. You know, the cost of the trucking industry is growing 20%. You know, 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. And then you get on their customers calls and you say, man, these rates are going up 10, 20% on it.

Starting point is 00:04:11 So you can triangulate quite a bit, the raw material costs. You can follow some of the suppliers of companies, some of their competitors. So it's good to follow, you know, 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 customer, suppliers, competitors, those sort of things, which, again, I think helps a lot in valuing these companies. Yes, Eric, and let's continue this discussion about valuations because I guess what most investors would do and with good reason is that they would look at the past five 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 starting for a long time because if we ought to say at the peak at a business cycle, those earnings might not show the right. picture of the true value of the company. So could you talk to us more about where you think we are

Starting point is 00:05:11 in the business cycle? I think we are similar to 1999 in 2006. I mean, profits are extremely high. Demand is strong. On average, you know, there's certainly some industries where it's not as risk. But, I mean, interest rates are showing us this, I think, right now. And 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. So what would be the indicator for you that we've transitioned to the next phase? Margins dropping unemployment starting the rise. I just had this conversation with Jesse.

Starting point is 00:05:48 It's kind of interesting. I think some people believe that rising inflation will print margins, right? I don't think that. You know, I'm seeing margins actually hold up because I think you're going to be able to pass on price increases. So what I'm envisioning is interest rates ending the cycle, right? Right? Higher discount rates because you can have these 100, 200, 300 increases in discount rates and multiples stay where they are. I mean, it makes absolutely no sense.

Starting point is 00:06:15 So I'm not a believer that 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 cycle. You know, this isn't much different. And then you have margins impacted once the cycle ends, right? don't see profits ending this cycle. We saw that in 1516 where we did have a profit recession and the cycle didn't end. You know, it hung in there pretty well. And that was because rates stayed low, right? And people remember Tina, there's no alternative. That was going strong then. But, you know, when rates go up, again, two, 300 basis points at these levels, at these valuation multiples, you know, that's a considerable risk that I think eventually will impact margins,

Starting point is 00:07:05 but it'll be because of demand, not price, not cost. So back to the trucker comment, what's the main driver for the 20% increase? Labor is a huge issue right now. There's a huge labor shortage, and they just implemented some electronic logging regulations, so it's making it much more difficult for truck drivers to, in lack of better words, 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,

Starting point is 00:07:34 You know, you could take up truck driving right now. It's a very good occupation to go into right now. So 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 analyst questions? Like, as a person who listens to so much, how would you interpret that? Is this just noise or is there something to this? Yeah, I wish I could comment on that.

Starting point is 00:08:00 That's a little out of my league, right? I mean, I can relate a little bit, some of the South Side analysts, some of these calls. You know, some of the questions are, they're not irrelevant, but they might be more towards, hey, will you fill out my model for me? Like, you know, and I've seen where management at times is like, come on, you know, do your job. You're the research analyst. I'm just supposed to fill it in for you. Yeah.

Starting point is 00:08:27 So I could understand where there would be a point. I don't know if that was the point. You know, again, I don't follow them. But I can understand where someone can lose their patience for some of the questions. You know, there's a lot of good questions. But again, I'd say, you know, every call, there's that going to notice that asks management that really fill in their model in a direct way. Now, why only small caps?

Starting point is 00:08:47 I mean, we just briefly talk about Tesla here that you don't follow. And one of the reasons might be because it's not a small cap company, but why not follow all the big companies too? Or some of them, I'm sure that would be mispricing there as well. Well, you really could. I mean, you could apply absolutely return investing to all market caps and you could do it international as well. But I found by having a fixed opportunity set, you know, that's really allowed me to get to know those businesses as well. And, you know, we go back to 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.

Starting point is 00:09:24 That would be much more challenging to understand these business as well. I wouldn't be able to go through some of the calls and, you know, I read them all, but there are. certain questions. I'm like, okay, you know, I already know this. You know, so you just move on and you can get through more calls quickly that way. So let me ask you this. What are the like the top two or the top three big trends that you're hearing on all these different calls? I would say the biggest trends I've really started to notice in 2017 is rising corporate costs, wages, you know, 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.

Starting point is 00:10:08 You know, 2015, 2016 is a lot different. You know, it's disinflationary. That's shifted in 2017. We could talk more about, you know, why that shift occurred. Another trend, I'm noticing, you know, business is pretty good. You know, it's interesting in that I still remain 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.

Starting point is 00:10:36 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. Would you say that the inflation is getting a little hot, or is it just healthy at this point based on the calls? I do not think we're currently in some sort of runaway inflation mode, but I think the trend has definitely shifted. You know, a lot of the price increases I'm seeing are in the low to mid single digits.

Starting point is 00:11:10 It's not outrageous, but it's there. To me, it's very obvious. And I think I see it, I'm fairly certain, I see it building in the pipeline. So when you see on these, are hearing these calls that they don't increase pricing right away. You know, it's their costs go up and then they respond. They don't raise prices right away. There will be a lag, you know, several-month lag. That's what I'm seeing now.

Starting point is 00:11:31 I'm seeing costs, pricing power, things I really haven't seen in a long time. You know, the last time we had this type of environment, I think, was probably 1999, where wages were growing 4 or 5 percent, and the labor market was very tight, and I'm seeing that currently. You know, Eric, a lot of the people that we talk to, they're pretty bearish on the fundamentals, just because of like the P.E. ratio, the Schiller P.E. being the second highest it's ever been, and the history of the market. I'm assuming you share some of this bearish sentiment, but where would we be wrong as far as like this thing could run a lot more

Starting point is 00:12:06 and the reasons why? Yeah, I mean, we could definitely be wrong. You know, I think back in the early 90s when Home Depot was one of the most popular stocks, it was very expensive. And, you know, a typical value investor wouldn't touch it. But it never crashed. You know, it sort of stayed in this channel for 10 years. I mean, I need a chart to verify that.

Starting point is 00:12:28 But what happened was earnings caught up with price over time. So it never crashed. And maybe that's what happens in the cycle. You know, maybe for five, 10 years, prices to stay in a narrow range and fundamentals catch up to valuation. You know, to where that normalized earnings of Schiller P goes from low 30s to back to 1617, just on earnings growth over time. That's, I think, one of the risks. And maybe, too, the Federal Reserve eliminates the business cycle, right?

Starting point is 00:12:53 It's possible. I still believe in the business cycle. I mean, 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 busts of 1560. The credit got pulled away and the energy industry plummeted. You know, capex plummeted, earnings plummeted, companies went bankrupt. If the variables and impact margins of industries haven't changed,

Starting point is 00:13:18 why should we expect the profit cycle and aggregate change, right? I'm still a believer. If I wasn't, if I did believe that the Prophet cycle was dead, and I, you know, I believe that evaluations wouldn't revert to the mean. You know, I obviously wouldn't be positioned how I am today. Let's take a quick break and hear from today's sponsors. All right. I want you guys to imagine spending three days in Oslo at the height of the summer.

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Starting point is 00:17:34 Go to Shopify.com slash WSB. That's Shopify.com slash WSB. All right, back to the show. Eric, you have this comment about inflation and a potential catalyst about how to change the inflation environment. So could you elaborate a bit more on that? Well, I go back to 2014. And at that time, the middle of 2014, things were going very well and things were starting to tighten up.

Starting point is 00:18:06 And, you know, obviously that was back when, you know, we started exiting the QB3 discussion. And we also got a bump from a very cold winter in Q1. So the momentum was there, earnings growth was there, and then the dollar spike at the end of 2014, if you remember, and then the commodity stocks and commodity industries took a huge hit, right, the prices of the commodity prices took a huge hit. And I believe that period, we really had, we didn't have a recession. It was close. You know, we had a couple quarters very low growth, but it wasn't negative, but we did have an earnings recession. You know, we had five or six quarters of negative earnings. what happened there is that bought the cycle some time. You know, it took a breather. And then it also allowed the foreign central banks, the ECB and the Bank of Japan, to step in and increase their quantity of easing. I mean, remember the ECB started to buy corporate bonds.

Starting point is 00:19:00 Yeah. And that was a big deal, right? I mean, that just, that really deuced things up. Spreads tightened. And then the energy industry was able to issue equity in debt again. And before you know it, things healed in the energy industry. And I believe that was a big deal because we go back to triangulating the companies and all different industries I follow. Well, when the energy bus hit, it wasn't just energy industry that was affected.

Starting point is 00:19:25 You know, that was a big credit generator, that energy industry. People were throwing credit at it, raising a lot of capital, and that was spilling over into the economy. It was kind of like a mini housing boom, right? Remember the housing boom? It didn't just stay in housing. you know, spilled over into the economy. The same thing happened with energy. All that credit, all that growth was spilling over into the broad economy. And that went away for 1516. And that's why we had sort of had that flat earnings growth, flat economy. And really, you know,

Starting point is 00:19:54 not a very impressive stock market either. I mean, for most until later, 2016. So that all changed. And now energy industry is back and it's turned from a headwind to a tailwind. And now you're seeing, you know, when the energy bust hit, I was seeing companies report X Texas. You know, I've never seen that before. You know, like, because this new non-gap, we're going to report our results and we're going to separate Texas from everything else. Now they don't report X Texas now that it's helping. But yeah, so just restaurants, retail, you know, we go back to trucking, industrial cyclicals, you know, things that sell valves, pipes, steel, you name it, railroads. A lot of industries were influenced are impacted by the bust and now the revival.

Starting point is 00:20:36 You know, for me, the whole energy sector really feels. a lot like 2007, getting into 2008 time frame, where we went on a really big bull market. And 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? You know, rig counts for up 30% year over year. Cap X, though, I would say right now, you know, and it can change. But right now it seems a little more discipline than $100 oil, you know, early 2014. team. So, you know, I'm a little reluctant to say we're going to spike like we did then,

Starting point is 00:21:12 but it's possible. You know, anytime you have this industry capital, they go, you know. Yeah. I can't remember a time when they stay disciplined for long. It's just in their blood. You know, they love production growth. They love it. And a lot of them are compensated on that. Some of their comp models are based on production growth. So that's what they like to do. You know, they're born to drill. And now the economics are just at 70. You know, they're pretty good. I was on one call. I think it was Patterson, UTI. The CEO was saying he was like, you know, we were growing at $50 one. You know, things were coming back at 50.

Starting point is 00:21:43 You know, now we're at 70. So to your point, you know, we could be back off to the races. 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. Yeah, I was introduced to the minor sector in 2014 and 2015. We talked about the rising dollar and the,

Starting point is 00:22:07 collapse and a lot of the energy names, you know, all of the miners were devastated. As a value investor, you know, that's sort of where you start to look around when no one wants to own them. And, you know, I go back to that period and it was very, very difficult to own and follow. But I got to know the industry well, because there was so few places to find value, you know, this was a little oasis of value. And I've spent a ton of time on it because there really wasn't anything else to work on, you know. I like when you're in a patient positioning, when you have a considerable amount of your holdings, you know, T bills, there is this uneasiness of not owning anything tangible.

Starting point is 00:22:46 Yeah. So that is a risk. You know, being patient is not risk-free. You know, you're incurring tremendous opportunity costs. And obviously, you're incurring risk to the loss of your purchasing power. You know, I much rather be, you know, I don't like holding cash. I much rather have a fully invested portfolio with, you know, $0.70 dollars, high-quality, small-cap businesses. So currently, I do like the idea of owning some miners. I don't own any now. I'm

Starting point is 00:23:11 getting through earnings season. There's a couple I'm interested in maybe owning again. You know, I sold the miners in the spring of 2016, the summer 2016. So I had a very fortunate exit point there. And they hadn't rallied for them. In fact, some of them are down considerably from their peaks in the summer of 16. So I do find some interesting where they're trading below what I believe is a fair replacement cost for their assets. So what are, you know, if you had to name one or two companies that you really like right now, what would those names be? You know, the six-month T bill just exceeded, I think it's 2.05 now.

Starting point is 00:23:47 Yeah, it's getting up there. In the two years, the 253. So if those were stocks, you know, 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 yield, you know, they're getting up there. Talk about this a little bit more for people. Explain exactly what you mean by that. Well, I'm saying if you normalize cash flows for the average company, you know, the average stock of my potential buy list is a little over 30 times earnings. You know, that's not even normalized. And prices of sales at 2.5 times. Very expensive. The S&P normalized earnings. I think it's around 32 times or maybe you know this better than I do.

Starting point is 00:24:25 Yeah. So that's a free cash flow yield. If you say earnings are a free cash flow, and that can be an assumption that maybe you could argue. Let's just assume that. So your 3% free cash flow yield of all the earnings were paid out to you by the SP 500 on a normalized basis. You'd receive a 3% coupon. But right now you could buy a two-year treasury and almost accomplished to that risk-free, you know. So two and a half risk-free or three percent with risk. If margins normalize, you know, that coupon gets cut in half, right? With rates up, you know, the stocks really haven't responded so far. I mean, the Russell 2000, right at its record high right now. Well, and 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, I mean, you're getting all of that.

Starting point is 00:25:16 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. So, I mean, the yield on the short end of the yield curve is coming up like a freaking rocket right now. And it's, yeah. It's fangs. It looks like a fang stock. Yeah, it does. It's crazy how fast. I find it exciting.

Starting point is 00:25:36 You know, I was at a social event a few weeks ago, and everyone was talking about their favorite stocks, and I was like, have you seen that two year? Oh, and then everyone grabbed their pillow and. No, but, you know, it's, I find it exciting to just watch yields go up and the market not pay attention. I mean, if people are talking about the lower taxes, right, going to 21%, but if you assume 100 to 200 basis point increase in your discount rate, you know, and say your discounting rate, you know, maybe 5, 6%, you know, I don't know what people are using that with it. That would have to be a low rate.

Starting point is 00:26:15 That takes all that away, right? Yeah. From a valuation perspective, the valuation map, the higher discount rate takes completely away the tax rate benefit. But all people talk about is the tax rate benefit, not what's happening with interest rate. You know what's so funny, Eric, is we're talking about, you know, two and a half percent on the two year. And after you account for three percent inflation, you know, your real return is a negative 0.5 percent. But you're comparing it to cash, which is basically a negative 3 percent return.

Starting point is 00:26:47 I mean, we're really, if we could just step back, you know, 20 years ago and play this conversation for ourselves. No, you're absolutely right. It'd be insane. back to 1999, you know, I talked about that's the last time I remember the labor market being this tight. You know, what were short rates then? Five? You know, I know that's where they were in 2007. Yeah. They were like five and a half. And you just, if I just read this quarter's calls, 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, and saw margins where they are and top line growing.

Starting point is 00:27:23 again, I would have to guess that we would be close to 5 or 6% on the short end. Yeah. You know, because if my companies are raising prices, three to five percent, why shouldn't short rates be around that level? I mean, we are at one and a half to 175 on the Fed Funds rate, and you have clear evidence of companies raising prices. Like, this isn't, you know, the CPI asked me, came out in like 0.1 or something, and I just shook my head.

Starting point is 00:27:51 I said, this is incredible, you know. Here you have corporate America telling us. I mean, they usually don't tell us, right? Because pricing is a very sensitive topic. You really don't want to broadcast that. You might upset someone or you might, you know, show your hand to your competitor. But they are showing, they are telling us on these calls. They are saying inflation.

Starting point is 00:28:10 I mean, they are actually saying this. They're saying this. Inflation is a problem. This is how we're going to address it. You know, your comment, Eric, really reminds me of the interview that we did with Bill Miller here on the podcast. And he said, looking where things are right now, this could be somewhere around the 5% range. And back then, you know, back in 2000, it was a silipy of what more than 40. And interest rates were tripled back then.

Starting point is 00:28:37 So why couldn't it happen again? I'm very curious to hear your thoughts about that, Eric. Because I think people believe the system can't handle it. You know, the safety net for rates is they can't go that higher because it would be a complete disaster. And hey, how that argument hold up for housing, right? It was the same argument for housing. Just looking at the trend line of the 10-year treasury. And like you can see that it's buttoned up against that 35-year trend that we've been on.

Starting point is 00:29:09 And 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, you know, actually materializes. And 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. And the long bond is interesting too. It's hard to say what the bond market is communicating to us because the Fed really hasn't reduced its balance, you considerably, right? So we still don't know what the real rate is, right?

Starting point is 00:29:46 It's still artificially surprised. but if we could gather information from the long end, I would speculate that it's telling us short end is going to continue to rise, but eventually it causes an accident and the long end is going to be right, right? Or we have another deflationary event. So I always say it's inflation now, and 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, you know, because then demand plummet's, right?

Starting point is 00:30:16 and then we're back to that QE4, QE5, and then regroup and let's start again. But in that transition period, there will be a slowdown. I think what the market is really surprised about is how fast this has changed. I mean, the one year, two year, you know, it's just, it's been taking off like a rocket. It's almost as if the two years running the show. You know, it seems to be functioning, and I like it. And it's, I'm not only getting paid more to hold these short-term treasuries. But I like the fact that just feels like markets are functioning again, at least on the shorthand.

Starting point is 00:30:50 I think it's the QT that's happening, the quantitative tightening. Right. In the supply. Maybe it's just that basic, you know, demand supply, right? Maybe diminishing or it has, right? The central banks aren't, or the Fed at least isn't buying bonds and they're selling them. And now we have fiscal deficits rising, right? So we've got to issue more dead.

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Starting point is 00:34:39 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? Well, you know, it's really for me, it's valuation based. So I can't buy these companies. And I don't use, I have never used these risk-free rates to value businesses. I think about what my required rate of return is as an investor. And historically, that's been 10 to 15% on small-cap stocks. So I'm thinking it from a perspective as a credit analyst first, what do I require for this business?

Starting point is 00:35:15 And then I apply a risk premium to that. So that's how I get my 10 to 50%. So that's my required rate of return. And at today's prices, there's just no way to get that type of return to small caps. 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. and that would be negative for stocks. I'm not making a call on stocks,

Starting point is 00:35:41 and I'm a horrible market timer. I'm just saying, if I was fully invested and I was paying 30 times plus for normalized earnings, I would be very concerned with rates where they are because they are competing

Starting point is 00:35:53 with you right now in a risk-free basis. And you're in a business with uncertain cash flows. So talk to us about valuation. Warren Buffett always mentions intrinsic value. How do you think through

Starting point is 00:36:06 your valuation of a stock pick? Do you use discount cash flows, multiples, a combination of approaches? I use a discount cash flow method. It's a lot simpler than most. I talked about the discount rate at 10 to 15%. So that's my required rate return. That's what I want on my equities. And over my career, you know, from 98 to 16, you know, that's what I achieved on the

Starting point is 00:36:27 equities. So people always say, you know, if you don't use a benchmark, if you're an absolute return investor, what's your hurdle rate? Or what do you compare yourself to? And I say, well, the return I'm attempting to achieve. That's my required rate of turn. That's what I'm trying to achieve. So I use that 10 to 15% discount rate.

Starting point is 00:36:44 And then I use a cash flow assumption that I normalize. You know, if you have a business over a cycle that generates 7% of EBIT margins on the trough and 13 on the peak, you know, you kind of use a normalized margin to come up with the normalized cash flow. So 10 to 50% 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, you know, they're not growing 15, 20% a year. Party-duddy in line with the economy companies. So you're valuing them into perpetuity. You're not just doing 10 years or anything like that. Yeah, because I've discovered over time.

Starting point is 00:37:21 I tried this when I was a lot younger. I thought I knew everything. I didn't. 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, I think, get a much more accurate valuation, because you can be wrong in year three, but then maybe you're right in year seven.

Starting point is 00:37:46 It all averages out. And I found normalizing keeps me out of trouble on the upside and downside. At what time frame do you switch over to basically the inflation rate, about 10 years, five years? No, I do it right away. So I'm using almost like a perpetual bond valuation. It's normalized cash flow over K minus G. So if I'm saying I'm at 12% cap rate, which would include, say, a 7% required rate 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 flow is at 8%.

Starting point is 00:38:21 $10 million, right, on the $8,000 cap rate was on $120 million valuation. But 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, you know, again, as a credit analyst, what you should require as return and then as an equity analyst or equity risk premium, what you should require for the added risk of owning the equity. So that takes considerable time getting to know the business. And it's why I like to follow the same companies. Because I want, you know, I want a good feel for the businesses. It's a lot easier to be following for 20 years, you know, because you've seen them. You've seen everything almost that they've done.

Starting point is 00:39:03 and what they've said, have they followed through with it, and every cycle, have the gains here, have they lost share? You know, you just see so much more they get a higher degree of confidence in your valuation by sticking with more mature businesses. So say that you're seeing this company and it has a declining or, say, a stagnant top line and, well, that would probably also be one of the reasons why I'd be priced at a very attractive multiple and then you're trying to base your valuation based on that. So talk to us.

Starting point is 00:39:31 How do you look at the importance of the top line? 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, you know, 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, you know, 3 to 5%. So that's something that's very important right now.

Starting point is 00:40:01 top line, but the health of the top line. Is it price or is it volume? You know, it's a big difference. And that can be the difference between a healthy economic expansion and stagnation. So, 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 kind of results? You know, when I was running a fund, I used Bloomberg a lot, their screens and I would have standard screens that screen on market cap and profitability. I would try not to weed out too many companies because, again, I normalize cash flows. So I don't mind if a company is generating trough results.

Starting point is 00:40:44 But that can knock out a lot of companies out of screens because their earnings will be down and their valuations will look elevated. So 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 possible biolus has grown and sort of stabilized, I think more recently, or in the past few years, more of my new ideas come from working on companies when I do my due diligence, learning about their suppliers, competitors, customers. And sometimes I'll bump into some of their public counterparts. And, you know, this is interesting too.

Starting point is 00:41:22 You know, and it just goes on my list. And there'll be some industries I thought I would never own, you know, like the call centers. I never thought of it on a call center. And it wasn't sure if they were high quality businesses. So yeah, so new industries occasional come on. But when I go through screens now, I've been doing it for so long. It's almost like, you know, I've seen this, you know, I know this. I know why I don't have it on my possible biolus.

Starting point is 00:41:43 And it's very rare that I come up to a new name. And if I do, it's usually a, you know, maybe an IPO that doesn't have a long enough operating history to include on the possible wireless. So it doesn't change. You know, usually maybe a name will go on once a month. And a name will come off once a month. My whole goal there is just to continue to improve the quality of my opportunity. Of the sectors that you follow, where do you see the bull case and where do you see the bear case?

Starting point is 00:42:09 Bolish would probably be commodities. I think energy is done fairly well, and energy 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 EMP still have a little too much debt for me. I do like some of the precious metal miners. I plan to work on Almosk gold, ALG. It's a debt-free precious metal miner. They have two mines in Canada, one mine in Mexico, or actually two mines in Mexico, but one that's actually a value.

Starting point is 00:42:37 The other one's almost full depletion. It has no debt, over 200 million in cash. So it's interesting potential buy idea that I plan on working on. So there are some, I think, miners now trading below tangible book or that's a replacement cost, evaluation I work on. Yeah, I'm looking at the top line on ALG and it's got a nice, steady growth to it. It's really nice. Yeah, the recent rise in gold has helped.

Starting point is 00:43:01 They've also done an acquisition, so that might have added a little more. But the main thing is their top three minds are generating free cash flow. So often when people think about miners, they're horrible businesses, right? I mean, that's what we were taught. But a good mine can actually generate cash in considerable cash over a cycle. Once it's paid off, you know, the development part is the cap. heavy part. But once it's developed, I mean, you still have sustainable KAPX. But once it's developed, you can generate a good bit of cash if it's a long

Starting point is 00:43:31 asset, you know, in their average reserve lives over 12 years. You've got 12 years of cash flow generation, considerable cash flow generation at these prices. You look at the energy industry, you know, what's an average well's life? You know, they go through a well pretty quickly. The reserves very quickly, you know, a majority of the reserve sometimes in a year. Well, a good mine, you know, the Young Davidson mine at an Almos is a 15-year mine. So even if prices decline and you're not assuming financial risk, which you're not assuming much because they have no debt in over 200 million in cash, you can get through the cycle. With a lot of energy names, it's a little harder.

Starting point is 00:44:07 You know, not only do the financial risk because many of them have debt, but the reserves are very short. You have to keep drilling every year, right, to keep replacing those reserves in that production where a mining company, those mines again, you know, will last over a decade. Very interesting. And how about the sector that you're bearish on? It's a great question. It's so broad the cycle. Usually, you know, it's pretty easy.

Starting point is 00:44:30 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 of death of Amazon. And I think the traffic in a lot of these malls is weighed down. How do you see retail today and kind of moving forward? Yeah, so we talked about retail the last time we talked. And I think we both thought that the sector had been beaten down considerably. And I would agree with that.

Starting point is 00:44:57 Really, the easier comps over a year, you know, that's sort of expected. But also you've had many of their competitors go bankrupt and that liquidation has worked itself through. Inventories are in fairly good shape. So, you know, I'm not sure I'm very enthusiastic about a lot of the valuations in retail. But, you know, I do believe the operating environment is in the process of healing and improving. and I think you're going to see more examples of full-priced sales because inventories are in a better shape,

Starting point is 00:45:27 and 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 promotions were running very aggressively. That I'm seeing dying down, which is going to help combs and profitability. Awesome. Well, the last question I have for you, Eric, is just, who do you stock on Twitter? Who is a person you pay a lot of attention to?

Starting point is 00:45:54 Or, I mean, 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. You know, I'm not on Twitter. I know I should be. But I was actually talking with our friend Jesse Felder about this because I know he's pretty active on it. And he gets a lot of value out of it. I just right now with my opportunity set the size of it is, I've even considered narrow it down maybe 200 names. You know, most of my time is spent on trying to keep up with the

Starting point is 00:46:23 companies I follow. So I just haven't had the time to get on Twitter and follow some of the brighter minds on Wall Street. So that might be it just advantage for me. Sometimes that might be an advantage too. I love it. You know, earlier in my career, I read more, you know, books, but as my opportunities that grew, my biolus grew, and then I started to find my own way. You know, I remember when I first started of the industry, you know, I would be interested in what Mario Gubeli owned, you know, Third Avenue, Longleaf, you know, I would kind of pick through their names. But over time, you know, I learned, you know, 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,

Starting point is 00:47:06 they can't do that by themselves. They have a team of analysts and you might be sure you picking off a 24-year analyst who just got out of grad school. So you gotta be a little careful there because there's this false sense of security of the great firm owns that, you know, a ton of work has been done. And maybe it has. Plus, just knowing the names well, I think it allows you to act more decisively. When those opportunities do appear, you don't freeze because, hey, I know this company. You know, I've been following it for 10, 15, 20 years.

Starting point is 00:47:38 I'm so confident in valuation. I'm so glad the stocks where it is and now I can buy it. And there's just no second guessing because you've done the work. 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. So if they want to learn more, where should they go? You know, I run a blog. It's free and it's Ericcinema.com. So it's pretty easy to find.

Starting point is 00:48:03 You can subscribe if you like. I plan to keep writing until I don't want to. 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. So, guys, make sure you go there and check that out in our show notes.

Starting point is 00:48:25 So, Eric, thank you so much for joining us. All right, guys. That was all that Preston and I had for this week's episode of The Investors podcast. We'll see each other again next week. 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.

Starting point is 00:48:58 This show is copyrighted by the TIP network. Written permission must be granted before syndication or rebroadcasting. PIT! TIP!

We Study Billionaires - The Investor’s Podcast Network - TIP194: Small Cap Investing & Intrinsic Value Calculations w/ Eric Cinnamond (Investing Podcast)

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