We Study Billionaires - The Investor’s Podcast Network - TIP257: Small Cap Investing - w/ Eric Cinnamond

Starting point is 00:00:00 You're listening to TIP. On today's show, we bring back our master of the small-cap enterprise, Mr. Eric Cinnamon. Eric has been a portfolio manager for over two decades and is a regular guest here on the investors' podcast. And on today's show, Eric provides a pitch on three different small-cap companies while Stig and I troubleshoot and ask Eric some of the contrarian and hard questions. This is a great episode if you're a student of financial valuation and trying to find undervalued picks in the marketplace and just generally trying to understand.

Starting point is 00:00:30 and how to think about going through that entire process. So without further delay, here's our discussion with Eric Cinnamon. 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. Hey, everyone, welcome to The Investors podcast. I'm your host, Preston Pishon. As always, I'm accompanied by my co-host, Stig Broderson.

Starting point is 00:01:06 And today, we are talking small, cap stocks like we said in the intro there and we got the one and only Eric cinnamon with us. Eric, welcome back to the show. So awesome to have you here. Thanks. It's great to be back. 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 companies that have piqued your interest. And we want to go a little deep into just a couple

Starting point is 00:01:50 companies opposed to just talking 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 what would be one of your first picks that you would want to talk about, Eric? 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. What they do is they manufacture and lease natural gas compressors. So it's pretty exciting business. It's about a 170 million market cap. So probably it's not going to make out 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

Starting point is 00:02:28 type of stock. 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 to 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. Well, it's a natural gas compressor. company, so it's tied to the EMPs, you know, the energy industry, and obviously extremely

Starting point is 00:03:12 cyclical. So I always like 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 is probably going to get worse with natural gas near $2. The business also is used for oil. So just overall, the industry is becoming much more disciplined with CAPX. You know, you see a declining rig count right now really says 2014 energy service has been. been, you know, pretty much in a bare 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 discounting future free cash flows. And I know you guys do on that as well.

Starting point is 00:03:54 Sort of that perpetual bond, 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. So this would be more of an asset. So, valuation where you can buy, you know, 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 see, 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 and the stocks at $13. So a significant discount

Starting point is 00:04:37 the tangible book, you know, 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. So, Eric, whenever you say we are the travel of the cycle, how do you identify that? Well, you can look at historical rig counts. That usually gives you a good indicator of where you are in the cycle, and right now we are 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

Starting point is 00:05:17 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 productivity wells, increased productivity. The compressors are also use to transport the gas from the wells to the midstream assets or the pipelines, again, very tied to the Capax of the energy industry. So overall, you know, it could go lower for sure, but that's why you want to have sort of an energy service company, a very strong balance sheet, which they do. You know, they have a 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.

Starting point is 00:05:58 They've done a good job historically of only investing when they're getting paid to take risk and they'll do it aggressively with their cash. And then when they're not getting paid, they won't. So it reminds me a lot of how we manage money. You're getting paid, take risk you should. And when you're not, you don't. And that's why you'll see their cash actually fluctuate on the balance sheet considerably. It's been as high as over 60 million and its lowest near nothing. But they do not, you're not going to debt. You know, it's very important that you have these strong balance sheet names. So you 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 their

Starting point is 00:06:31 competitors, some of our LPs, they pay dividends. their cash flows are constrained. Their balance sheets are much more levered, highly levered, many of their competitors is 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, I'll have great balance sheets. And I think that's the theme we're focusing on right now.

Starting point is 00:06:53 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? 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 is an owner of, or if you're renting these compressors, and by the way, they do rent, most of their revenues are for rentals,

Starting point is 00:07:21 75% and the other quarter is sales of the compressors. So it's actually a pretty good business. You know, the rental gross margins are very impressive. But yeah, I mean, they will get. some large clients because of their balance sheet. Let's go into a little more detail with industry itself. What are you seeing right now? The low prices, you know, natural gas right now is near $2.mc, which is very low,

Starting point is 00:07:46 well below break-even for a lot of companies. It's so much production, especially with in the Permian and the oil-related areas where natural gas is a byproduct, you can't give it away. You know, the only thing worse than natural gas right now, I think it's toxic waste, you know. You have to pay money to pull it out. I mean, you could flare it, but you could only flare it for so long. You know, you get a license for that.

Starting point is 00:08:05 So yeah, you should probably pay attention to the cycle, 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. You know, if these wells end either lives are 12 to 18 months or the majority of their lives are, you need to replace these reserves, you know, about 25 percent a year. Two dollar 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 five-year average inventory, it's not that bad. And if you look at demand, it's been growing quite a bit.

Starting point is 00:08:37 You know, 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 we're going to be exporting and have been. And that's probably going to double in the next couple of years as well. So overall, you know, I'm not too bearish on natural gas, but it's just, it's definitely contrarian right now to own anything related to natural gas and for natural gas services actually has it in its name, which probably creates a 20 to 30 percent discount alone.

Starting point is 00:09:08 Yeah, they need to rebrand it. I'm kind of curious if you are, when you talk 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? We could probably only discuss what we've owned at June 30th. That's our last disclosure. We owned a small weight at that time.

Starting point is 00:09:33 But it's a 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. You know, 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, they just released earnings. And the tangible book, you know, remains steady, actually grew slightly.

Starting point is 00:09:52 What's really interesting about these cyclicals, you know, this isn't normally what we own. It's just to be clear. Normally we want to own that perpetual bond, that steady eddy. But this is the environment we're in where these steady eddies are so expensive. You know, 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 low back 10 years, the Tangible Book was around $10 in 2008 and now it's around 19. I mean, it's a nice compounder on Tangible Book, you know, and I know a lot of value investors look at that.

Starting point is 00:10:25 They always want these compounders. But you can compound in the cyclical nature and still go from $10 tangible book to $19 tangible tangible tangible book and still have a nice, you know, 7, 6, 7% annualized tangible growth in book value, but it's just lumpy. 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 consultant, 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.

Starting point is 00:10:55 I mean, remember the last time we talked. Same thing. 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. 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. You've got long days of daylight, incredible food, floating saunas on the Oslo Fjord. And every conversation you have is with people who are actually shaping the future. That's what the Oslo Freedom Forum is.

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Starting point is 00:15:24 stocks that are very unpopular, and you've got to be right. So let's talk about the next stock pick, GenCore Industries. The stock ticker is G-E-N-C. Please tell us what they do and why the stock is on your radar. Well, they are a market leader. They share market leader status with Aztec Industries, ASTE. 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 and 2014, there was a bill that provided certainty. And then the FAST Act came in, and I believe, actually, I believe that was 2015, and that expires September of 2020. That created certainty for the industry. Sales for Gencore went

Starting point is 00:16:11 from $40 million to $100 million. So they spiked. And actually earnings looked very good over that period. Extremely cyclical business. But again, depends on the certainty of highway funding. If 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 with their backlog is declining. The earnings are declining, and the revenue is probably 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. 100 million 11 of that is cash in marketable securities, extremely liquid balance sheet.

Starting point is 00:16:47 And they have 27 acres in Orlando. own free and clear near downtown Orlando. So there's an undervaluation of real estate as well. 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 or something. It was very close to the current number of assets. Yeah, that's right. Explain to people what that means. So the 162 million of assets, so you're buying the business for 175 million, and it has 162 million of assets, and 154 million is current assets.

Starting point is 00:17:29 111 million of that is actually liquid in cash and marketable securities. It's interesting story how they got their cash. They built two synthetic plants for carbotronics. This was a long time ago. Part of the payment wasn't just in cash. They gave them ownership of two of these plants, and they got massive tax credits for these. potentially large cash payments. I mean, they've got a ton of cash. It is invested in some of corporate bonds and equities as well, so you should know that there's some market risk there. But what this

Starting point is 00:17:58 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 their 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 are natural gas services as well. What you have is with Gencore, a book value of 150 million. Most of its assets, right? So it's like 160 million in assets and 10 million in liabilities. I mean, that's really incredible where you don't have the risk on the liabilities. And usually when people look at book value, they're just thinking of their assets, but there's also liability risk. Well, and I think it's important that if a particular

Starting point is 00:18:36 company like this is being traded heavily based off of the book value and you have all those risks on the balance sheet, now all of a sudden the valuation gets really elastic. I guess 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 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 that what he just described because that's, I mean, that's a huge tip. Yeah. And another thing I would recommend, and again, these are all sort of tangible book valuations. Look over a long period of time and through all their cycles and look for the write-offs.

Starting point is 00:19:17 because you can have a large tangible book, which in this case we have with NGS, not so much with GENTCOR, but that's much more liquid. We can talk about that as far as the discount goes. But if you go back to natural gas services and look at historically after the crash and the energy industry, and then you look for the rideoffs, and actually in 2014 was a very nasty environment, and they had a tiny rideoff. It was like $900,000 net, very insignificant relative to $300 million. But if you look at a lot of energy companies, yes, you can find plenty of discounts to

Starting point is 00:19:47 look, but if you look historically at them over a long period of time, especially the E&P companies, you'll find multi-million dollars, 100 millions of dollars of rideoffs. That's very interesting, Eric. And in continuation of this, what is the big risk factor for JNCore Industries? Where could you be wrong in your assessment? The allocation of the $11 million in cash. So it's a good thing and a bad thing. But historically, you know, they held on to this, and I think they could do an acquisition

Starting point is 00:20:13 in the future. but I think they've done a good job of waiting. 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, you know,

Starting point is 00:20:38 and you could come up with it $4 million or so in free cash a year. 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 for them. Interesting. Okay, well, let's go ahead and try this last one here, the Crimson Wine Group. And this is a ticker CWGL. 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, you know, away from the perpetual bond high quality names. You know, everyone wants to own a franchise right now in wide moat. Those are

Starting point is 00:21:12 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, you know, in the small cap crowds and the ETSs and the crowd of mutual funds. So this is another one extremely underfollowed. They don't even do a press release when they announce earnings. It's called a CREBSon Wine Group, the symbol CWGL, getting very underfellowed, 170 million market cap, 211 million in stockholders' equity. And they're a winery, and we believe their acreage, specific their NAPA acreage is undervalued because it's on the book at cost. They started this building these assets in the early 90s. So this is a neat one. And if you're in a period of

Starting point is 00:21:54 unlimited quantity of easing and you want a hard asset, that's something might be for you. 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.

Starting point is 00:22:31 Is that pretty normal? You know, it's all over the place. You know, some of them like a constellation brands have pretty high margins. This, they do ultra-high-end wine. So their margins are all over the place, too, actually. Their gross margins. And what you have is 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 grapes. So grape harvests are how are weak, you know, which we've had over the past three years.

Starting point is 00:22:57 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're valuing the acreage of, of the winery or the vineyards, and we'll take each of the properties, apply a per acre value, and get to a value on their acreage. And then we value the inventory, which is very high and value the assets of the wineries. And Cremsen doesn't have necessarily high, high operating margins over a cycle. They tell us to buy these high ROE companies and high margin companies, high profitability. But low return on capital businesses aren't always bad investments,

Starting point is 00:23:33 because you are not the one paying the capital price. You know, that's some capital someone else paid for that capital, whether it was reinvested by the company or someone else, you know, 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 0.7 times valuation, that's what I'm paying. I'm not paying full price for that capital.

Starting point is 00:23:55 Very important to look at the price you're paying for these businesses and 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. Let's take a quick break and hear from today's sponsors. No, it's not your imagination. Risk and regulation are ramping up

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Starting point is 00:27:56 crash, they actually held up and it didn't decline. But if you put that against, like the San Francisco property values, residential real estate, and not correlated at all. I mean, those collapse. 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, you know, this doesn't mean it will happen in the future, but historically, they've held up well and appreciated well. You know, there's only about 47,000 acres, or believe it's 45,000 acres of Napa Valley. acreage in California. But again, you're not going to get there on the income statement. So on this one in particular, when you look at the price movement since the middle of 2017,

Starting point is 00:28:38 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 has broken out. or kind of demonstrated that something has changed. So is this one that you just kind of put on the shelf until you do see a breakout in that volatility range? Yeah, this is one that, and that's why we became interested in the idea.

Starting point is 00:29:09 Jamie found it really because it had been declining for so long. You know, we've been doing these screens on asset heavy companies. This one showed up. It's another one, you know, $211 million in Stockworth's Equity, we believe it's undervalued, and it showed up at a nice discount. So, yeah, these are sleepy ones. I don't even think anyone knows when they announced, they don't do a press release.

Starting point is 00:29:28 It's very sleepy. Boring is often good. And that's really what we're looking for right now. High quality asset, we can buy a discount. And, yeah, we'll just put them in the portfolio and let them sit, you know, let them mature. You know, I've had these before where you wake up one day and something happens, but you don't know when that day will be. Yeah, it's kind of surprising to me.

Starting point is 00:29:46 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 be sometimes a very painful experience because you'll see it operating inside of that range. You don't know if it's broken out or not. So another thing with these smaller ones and these asset heavy companies,

Starting point is 00:30:27 you know, we talk about the competitors having a lot of debt. And the reason for that, you can borrow, use these properties, these assets as collateral. So it's very rare to find these type of asset heavy companies without debt, just again,

Starting point is 00:30:39 because of the ease of borrowing. And so I find that very refreshing. There's other ones out there that I can find a discounted book, but they have a lot of debt. You know, there's farm rates. You know, I was interested in a farm rate.

Starting point is 00:30:49 I was looking at it recently, but I had too much debt. So going back to the current assets, you know, they have $107 million in current assets and only $7 million in current liability. So, again, very few liabilities. It's just hard to get the liabilities wrong or just not many of them in quite a bit of liquidity. It's very rare to find a hard asset companies with clean balance sheets and no debt. Yeah, I'm looking at on our tool, we have a thing called a mini balance sheet. And for the assets on this company, it's $10.67 per share, compared to $1.75 per liability.

Starting point is 00:31:22 And I mean, that's just, it's huge. Yeah, it's incredible. And, you know, insiders own 22%. They're actually spun out of Lucadia in 2013. They didn't really fit. So you have some insiders consistently buying, you know, not a lot, but just a little bit. They never sold a stock. So, yeah, this is a sleeper and probably won't do anything.

Starting point is 00:31:41 It'll probably drift and go down and bother us and probably buy more. So this is my question. 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 learned from this latest earning season? 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 in the cycle. And then Q2 was, it wasn't recessionary. You know, I think a lot of bears, and, you know, I put myself in that camp, the cash in the portfolio was about 92% at the end of June.

Starting point is 00:32:17 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 you're going to have a week Q3, Q4, and some of the industrials as well, you know, obviously with export concerns. So it's definitely more mixed picture, but I don't see it as an environment where we need to be panicking at this point.

Starting point is 00:32:41 You know, all bets are off. You know, we have 20, 30 percent decline in an asset. prices. 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've got all these negative interest-grade bonds, especially over in Europe. The U.S. 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? You know, we don't use sovereign debt or yields or risk-free rates for our valuation purposes.

Starting point is 00:33:15 You know, when we discount future-free cash flows, we're typically using what we lend to a business and apply risk premium to that, because, in our opinion, risk-free rates, I have nothing to do with the risk of the cash flows of a business are very little to do. You know, outside what happens to the economy or the result from the economy of those low rates.

Starting point is 00:33:31 So it hasn't influenced our valuation process, but 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, 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'm like, here's a fiduciary on television, you know, already explaining people are really justifying how you can own these things.

Starting point is 00:33:57 It's concerning. Yeah, you hear that argument about having no risk. And as long as you don't have a competitor to a field-based currency system with a fixed monetary baseline to some extent, one could make the argument. that this rate can continue for a little while, even though I don't think that risk-free is the right term. Perhaps Root Awakening might be the term we're looking for here. Root Awakening is some very uncomfortable client meetings. When they have to explain how they bought 30-year debt with a negative yield, I'm glad I'm not going to be in that meeting. I hope it doesn't

Starting point is 00:34:31 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. You know, labor market is still pretty tight, economy is not that bad. I mean, it will be if the market crashes, for sure. You know, definitely a very nasty recession. But as it is right now, why these decisions are being made, things are not that bad to even be contemplating these type of rates and these type of policy measures. It's very concerning. Crazy. Yeah. Yeah, just say to least. Well, Eric, I'll tell you what. We just love having you on. You're a breath of fresh air because you are, you are down in the smaller businesses and just doing business.

Starting point is 00:35:09 the way business should be done. And I love it. So thank you so much for coming on and talking these three companies. I'm sure people who were hearing how you described this, 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? Yeah, well, we launched Palm Valley Capital. You know, we got a fun now. It started in April, Palm Valley Capital.com. You can look us up. We've got a blog there, you know, check us out. Fantastic. We'll have a link for folks that are listening to check that out. And thanks again for coming on the show. Thanks, guys. Appreciate you having me again.

Starting point is 00:35:45 All right. So at this part of the time in the show, we'll play a question from the audience. And this question comes from Adrian. 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 it to put, say, 10% towards this pick for an 8% to 10% return versus 5% of another pick for a possible 20% return, but may include a bumpy ride with some additional risk? Or are you determining sizing base of industry and economy at that moment in time or some sort of blended approach?

Starting point is 00:36:25 Thanks, guys. I can't wait to hear back. Thank you for your question, Adrian. Radalia has famously said that having 15 uncorrelated assets is the first. wholly 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 guiding 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

Starting point is 00:36:58 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're uncorrelated with the stock market. So I also have a private business, I own some real estate and a few other assets. That really also influence on 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

Starting point is 00:37:25 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 principle, but have a high upside that just, 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 a portfolio as there are investors. If you look away from ETF investing, which is different and you only focus on individual picks,

Starting point is 00:37:53 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 nonexisting, 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 a watch list. And it's probably not worth your time. You can, of course, also choose to buy an ETF. And the ETF that investors typically buy is a market-weighted ETF, meaning that the bigger companies are overrepresented. So, for instance, in the SAP 500, Apple might be 4%. So if you buy the biggest and most diversified ETFs, it might even be an equal weight

Starting point is 00:38:37 ETF and you buy the stock market, you would typically not need more than two or three ETFs. 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 and has very, very little volatility. I recommend that you do not have more than 10% of your portfolio and one security. And this is only insecurities where you think that the long-term, 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 can 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

Starting point is 00:39:19 Redella said about having 15 uncorrelated assets and why that is so important in investing. So this is such a very, 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

Starting point is 00:39:52 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 AISockcharts.com. We'll have a link to that in the show notes if you want to check it out. But 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, a 10 or 15 stocks and you want to see how correlated they are,

Starting point is 00:40:20 you can use this tool to figure that out. It's very useful. And, you know, 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.

Starting point is 00:40:58 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 ask the investors.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's links to TIP finance and also the TIP Academy where you'd find the intrinsic value course.

Starting point is 00:41:30 All right, guys. That was all that Preston and I had for this week's episode of The Investors Podcast. We see each other again next week. Thank you for listening to TIP. To access our show notes, courses or forums, go to theinvestorspodcast.com. This show is for entertainment purposes only. Before making any decisions consult a professional. This show is copyrighted by the Investors Podcast Network.

Starting point is 00:41:54 Written permissions must be granted before syndication or rebroadcasting. I'm

We Study Billionaires - The Investor’s Podcast Network - TIP257: Small Cap Investing - w/ Eric Cinnamond

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