Value After Hours S06 E12: Eric Cinnamond on small cap value, absolute return, and the stock market

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Prior to founding the forerunner to Acquirers Funds in 2010, Tobias was an analyst at an activist hedge fund, general counsel of a company listed on the Australian Stock Exchange, and a corporate advisory lawyer. As a lawyer specializing in mergers and acquisitions he has advised on transactions across a variety of industries in the United States, the United Kingdom, China, Australia, Singapore, Bermuda, Papua New Guinea, New Zealand, and Guam.

He is a graduate of the University of Queensland in Australia with degrees in Law (2001) and Business (Management) (1999).

This meeting is being live streamed this is value after hours I am Tobias Carlo joined by my co-host Jake Taylor as always our special guest today the inimitable Eric cinamon how are you sir welcome Eric good to have you on great thanks for having me um you know we

Talked before the show and I think we’ve already blown through all the a material so well well welcome to Toby’s bside so Eric just uh for folks who don’t know you you’re you’re with this your firm or your one of three co-founders Palm I’m going to say Palm

Valley Capital Management have I got that right Palm Valley Capital Management and um I co-manage a small cap portfolio it’s absolute return focus and the co-manager with me is Jamie Wiggins uh very bright analyst manager and uh our other founder is Frank Martin he’s sort of the Godfather of absolute

Return investing um he he helped finance us and get us started in 2018 so uh there’s three of us you know there there might only be three of us left on this planet that run money this way so uh you know hanging tight holding on and um so

Far so good we’re we’re surviving can you explain Eric what the difference is between absolute return approach and a and a relative return approach yeah you know absolute for us is an attractive return over a full Market cycle you know and we we discount our cash flows and our valuations at 10

To 15% so you when people ask what does that mean it means we’re trying to achieve our objective on each Equity idea we purchase which is 10 to 15% and historically we’ve done that you know in our equities uh but what’s very different about this strategy is we can

Hold cash when valuations are expensive and don’t make sense and we can’t achieve that absolute return objective on the equities so uh cash can fluctuate for being fully invested to you know we’ve been as high as 90% or so um and right now we’re in one of those periods

Where we have quite a bit of cash so so relative return investing fores you’re just thinking about the Benchmark I’m trying to keep up trying not to look too different you want to beat The Benchmark of course uh but you can’t look too different might you’re fired you know so

It’s it’s a relative investing is a little tricky you know you can lose 30% and still look good relatively and that for us and a lot of our clients you know they have no interest in that you know being down quite a bit but being a benchmark uh that doesn’t doesn’t pay

The bills so to speak so yeah it’s really different you know this is how money was run in the old days you know you find Value you buy it and when you don’t you you don’t uh it’s very common sense uh tilt but uh yeah I think you

Know all the passive investing right now uh you know the relative return I think is uh definitely the majority of of how most assets are allocated these days what’s your bogey what’s your return bogy for putting something on um you know we use the S&P 600 but um

You know you could look at I guess all all the small benchmarks the Russell 2000 Russell 2000 value they’re all kind of similar since Inception of the strategy so but we don’t we don’t spend too much time on it we’re just we’re required to have a benchmark but it’s

Not something we really pay too much attention to I mean more in terms of like what’s the internal hurdle yeah what sort of return you do you need before you’ll think about putting it on the the absolute return yeah yeah 10 10 to 15% annually on the equities yeah

Um you know since this strategy or since the fund the strategy has been around for a while but the fund itself was launched in 19 March April 19 and uh we generated seven and a half after fees with which is a little better than the

Russell uh about the same as the S&P 600 but you know the equities because we’ve only been about 20% invested over that time the equities return over 20% annually since Inception so the equities have done very well so we’re really happy about that just we’re happy about

Being able to keep up um with the market without risking that much Capital so uh again we have our fiveyear in April so so uh you know we’re hanging in there we’re obviously we position as a last disclosure you know we’re not going to uh we’re not going to be up 23% this

Year unless prices get a lot more interesting you know anything like that or you know even hitting our equity required rates of return on the portfolio that will be tough because of all the cash so the cash can bring down returns over time um but the equity performance can do quite well because

We’re not being forced to be fully invested we’re not being forced to overpay and that often for us anyways enhances the equity returns yeah I’m it’s fairly astonishing to me actually that given this time period that you’ve been operating and and to to be beating a fully invested Benchmark is

It it speaks to the the good things that can happen with an opportunistic mindset yeah and you know it takes it takes years you know you can look at certain periods and we’ll look really really stupid and then there’ll be certain periods where we’ll look you

Know very smart but you know overall we just want to look you know relatively intelligent over full cycle uh but the tracking eror is insane um so you have to have the stomach for the relative uh tracking ER or the underperformance you know there’ll be certain periods where

We underperform by so much that it can make a lot of uh professional allocators nervous U so so we don’t tend to get a lot of business from the institutional Consultants because they’re very focused relative but we do get more business with sort of an advisor that has a

Private client they may have sold their business and they just can’t afford to lose 30% because they’re 65 years old and just you know they can’t do it again so uh we talked earlier we’re nice like a sliver strategy usually not a strategy uh you you keep all your assets for kind

Of a satellite sliver that provides um lower correlation to the benchmarks and hopefully again you know a nicer turnover cycle you uh I read through some of your commentary and some of your blog posts you you say that there was a and you’ve invested through this whole period

Through the late 1990s early 2000s most recent period you said that you feel like the market changed quite dramatically post 20 8 when the the FED bailed out Wall Street in its entirety can you talk to that a little bit yeah you know before 2008 2009 you know quantitative easing just wasn’t a

Thing you know didn’t jaes it just was it was something taboo uh you know and here we are with the fed’s balance sheet over7 trillion dollar and we started you know Toby talked about this earlier I think we were about n 800 900 billion so uh yeah before the the rules have

Changed you know where the government can come in and buy debt uh so that’s very different and if you look at really 2008 to now uh a large portion of the returns in the stock market are for multiple expansion um not necessarily you you haven’t really earned it youve

Just kind of been given it uh kind of a subsidy from the Federal Reserve it’s created a tremendous amount of asset inflation uh so what we do is we normalize cash flows and we use the required rate return We believe is commensurate with the risk of a business

So we don’t look at the risk-free rate so when rates were at 0% we weren’t lowering our return objectives you know we were trying to stay true to our discipline and there just wasn’t a lot to buy if you didn’t use 0% rates as you’re guide Guiding Light um so you’re

In a period of quantitive easing you’re in a period of massive fiscal deficits you know we talk about uh Pro former earnings if you didn’t have $2 trillion fiscal deficits on a you know $27 trillion economy I can guarantee you if that if we balanced our budget we would

Be in a serious recession if not depression um I’m not saying that’s the earnings you should use but you shouldn’t I don’t think you should be extrapolating these earnings today that are being goosed by federal spending you know uh the government spending’s gone up from four trillion to over Six

Trillion uh really over the past four years I mean it’s amazing so you had this emergency spending in Co but it never came back it never really converted back to where we were um and then you have the deficits and everyone’s like geez why are earnings holding up it’s such a

Mystery the government’s flooding the the you the country with money and wealth you know wealth perceived wealth anyways uh home prices around here you know we live in P VRA Beach Florida you know three-bedroom two bath I’m embarrassed to tell you what that would probably cost you um it’s just the the

Amount of perceived wealth uh from the asset inflation and then you throw on fiscal deficits on top of that and and again I just I think it’s you know why earnings why are earnings not rolling over why are we not having a sof Landing you know it’s just it’s pretty

Self-evident you know um but see our position is and why we’re not fully invested is all of this is unsustainable uh we’re going to revert to means uh we’re going we’re not going to have 12% profit margins and definitely you know historically it’s more like a 6 to eight

Margin um so we are betting on the cyclicality of human behavior the cyclicality of the economy cyclicality of markets eventually overwhelming all of this artificial interference um and if we’re wrong you know we talk we joked earlier I might start a pizza shop if we’re right you know U I think we’ll

Serve some people well including ourselves and and that’s why we launched you we launched in in 2000 we launched the firm in 18 launched the fund in 19 but our whole objective uh is that absolutely return but it’s also this cycle has just been so insane uh from so

Many perspectives that we believe at the end of it there will be a pot a goal you know waiting has to pay off there has to be a reward for this pain value investors are going through U and when that happens you know just like

0809 um it’s just it’s so when the bids disappear and there’s all these values you know you’re you’re a kid in a toy store it’s so much fun but to do that you got to enter the store with some liquidity you can’t be fully invested uh you can’t be overpaying for quality

Which is extremely expensive right now um but you gotta kind of look stupid right now you know I think that’s the that’s the uh that’s probably our strategies to look maybe as dumb as possible when every when most people are looking like Geniuses Eric do you have

Any sense of let’s say you know profit margins I think peaked out at 13.3% there for S&P 500 if you were to normalize let’s take out a trillion dollar deficit that’s just you know kind of a sugar high and take out really low interest rate cost so

Interest expense for the S&P 500 where would margins be if we kind of normalize the you know the the dox mackina version of you know government intervention you know I mean in aggregate it’s it’s hard to say you know because we look everything bottom up but

I would say from a bottom up perspective Ive I would I would say on average with within our opportunity set I would think margins are probably 40 to 50% higher than they should be and and a lot of that again is is the government funding the fiscal stimulus uh but also you

You’ve had uh after covid there was a lot of supply chain issues a lot of it was hard for people to uh to find labor and what a lot of the companies we follow have done if is they are making less to make more right so so they have

Because because of Co they figured out hey we don’t have to sell a ton of volume a ton of price we don’t have to max out our our factories our facilities our distribution we can pull back and just raise our prices and it’s cool to lose volume especially the low profit

Profitable things uh so that had a really positive impact on margins and and kudos to a lot of the companies for figuring that out you know you don’t have to run at full capacity to make money you know Ralph Lauren’s a great example of of many things but one is

They just started jacking up the prices over over the past three years I would think and margins have done very well the stocks done well profits are booming uh but they’ve also had the Tailwind of the wealthy you know apparel is not doing well right now but Ralph luren is

And that’s because of pricing and the affluent having so much money to buy a really nice uh shirts and slacks and not like the Amazon essentials I’m wearing right now you’re about you got yeah I saw you you had a discussion about quality in your blog post on WD40

Which a lot of people know because everybody’s got a count of WD40 everywhere in the world I think and they’ve put it they’ve they’ve done that brand extension where they stick it in everything else as well so you can you can get your tea joking I said that you

Know how are they goingon to grow they gonna start putting this in toothpaste yeah I think so I think that’s their plan cologne I it was cover in that green world book too it was like that poster child in that green World Book for something that couldn’t really grow

But like threw off a lot of cash flow yeah it’s a great business for sure it was an interesting analysis you said that for most of its life it’s been reasonably valued stay between 15 to 20 and then since 2008 the pe’s expanded quite a bit with nothing else there’s no other change

Really in the business yeah and I think the two major factors that we talked about in the block post were uh it’s almost a perfect correlation to to QE you know you you monetize debt and Peg rates at 0% a Perpetual Bond type business will look really attractive you

Know now you don’t demand a 8% free cash flow yield with rates at zero you know maybe 3% looks pretty good uh and in fact now it’s a 2% you know ear yield with rates at five so that’s not making a lot of sense right now but that’s a

Whole another topic uh but then you have the passive funds too the largest holders of this of the stock or passive funds um and that’s almost also a perfect correlation to the AUM of the pass passive strategies or the funds own it versus it’s multiple so uh yeah QE

And and passive there has been a very uh powerful com powerful combination for valuation yeah that’s interesting way to think about like WD40 is equity is is basically like a 50-year bond right so of course that much you know that much duration when you change interest rates

Is going to really move that the price of that yeah and a lot of the free cash flows paid out is a dividend um so you’re not really growing internally or you really can’t you know as long as you’re paying all that out a lot of it

Out even more Bond likee then yeah yeah right an equity comp too so yeah it’s it’s it was interesting uh analogy U or example I guess of you know what’s what we’re seeing with the quality and those are the kind of companies we want to own

Uh but you just you know with two 3% earnings yield really closer to two now you know that just doesn’t make sense especially you where rates are not that we use rates entirely but you’re just like you know a few years ago 0% rates were the reason you would buy pay 50

Times but now the rates at 5% you’re still buying it 50 times yeah how does that work how does that work well I think it’s like a super inverted curve right now right like inverted yeah inverted I mean close rates at five the 10 year at whatever what is it now two

Or three or something and then 50 year uh back at at two or something yeah but you think about um you know normalized multiple now for the S&P you know let’s just say it’s 33 times you know or 3% um you know 3% versus 5% or 4% you have

A negative equity risk premium you know I mean you know at this part at this stage of the cycle um you know when I talk and I was old reluctant to come on I talked to Jake about this is I feel like I just I all sound crazy you know

Um but when you think about all the crazy things going on right now uh you know the fiscal deficits I mean political uh geopolitical the profit margins uh government spending uh I mean it this goes on and on the threat of quaning and here’s the crazy one the FED is going to

Is is really threatening to cut rates uh right after they just lost 20% of our purchasing power you know it’s like are you serious I mean this is how you rebuild your credibility uh while inflation now is starting to pick up and there’s a lot of a lot of reasons inflation is

Starting to stabilize and go back up and we could talk about that but so you have all these things that are just you know insane and then these value investors that preach discipline patience maybe now is the time to earn 5% instead of chasing a 2% free casual yield we’re

The ones that are crazy it’s you have you have a negative risk Equity Equity risk premium right now with all of this going on um in the extrapolation of profits which you know has never happened before we never had a linear profit cycle perpetually it’s never happened so you’re betting on

Something has never happened and you know in work rate crazy you know so so uh maybe AIT defensive I’ve talked about it a lot on this podcast but I follow the yield curve I haven’t talked about it more recently because it’s Gone Bananas but the the yield curve the

10year has sort of moved up and down I don’t know if it floats freely or or how it’s how it’s how it’s priced but the short end of the curve the 3 month the twoe whichever one you prefer that’s clearly that’s the FED pinning it up the

The the 3 Monon is higher now than it was 12 months ago which is much much higher than it was 12 months before that all of the yield curve un inversion that happened last year all that normalization was the 10year floating up and then somebody got the cold spoon out

And that fell pretty quickly it’s sort of been it’s been floating around the thing that typically ends these yield curve um inversions is the Fed getting spooked and pulling down the front end of and that just hasn’t happened yet like it’s higher now than it was last this time

Last year when it was already an old inversion but now it’s the longest yield curve inversion ever at its steepest point it was the steepest yield curve inversion ever if this doesn’t result in a recession then you probably got to throw this out as an indicator but it

Seems to me that this doesn’t portend good things for the stock market when this sort of finally normalized it’s just like the cyclicality of the economy and profits it’s hard to throw out those kind of things you know they just they make too much sense uh but I would say I

Think the FED did get spooked when rates the the longer term rates hit 5% and that was uh October November December and um you know I remember at the time everyone was like why why are they pivoting you know what’s going on and well the cost of debt you know 5%

Government is that yeah so you know fiscal um spending on interest expense now is you know as everyone knows is a trillion well that’s double you know from just a couple years ago so I think I think uh that 5% kind of freaked them

Out and and now with the uh kind of the threatening to cut rates I think this is a strategy to help fund the deficits but also to uh strongly encourage uh people to move out on the curve um and buy debt because rates are falling you better get

Out buy better buy them now you know even though we’re issuing two trillion in debt more every year uh they’re going they’re going fast so yeah don’t make me cut four times it is hard to imagine a scenario that’s barring just some absolute incredible hail Mar technology

Advancement that lands and maybe AI is that I don’t know robots and whatever but where there’s not just kind of continuous ingredients for inflation to be kind of persistent for for quite a while I don’t know you know I mentioned I mentioned earlier uh some of the

Things that are reversing you know that we’re seeing with our companies from the bottom up there was a tremendous amount of inventory destocking last year and that’s run its course so you’re not going to need the amount of promotions and inventory uh you know you know you

Have to dump your inventory and with that also did when people are reducing their inventories well one also they’re doing that to to to generate cash was was very effective um but they reduced Freight you know Trucking prices collapse uh because everyone was destocking over the inventory that’s

Over there’s a lot of excess capacity coming out of the trucking industry right now because these rates don’t make sense and of course you have price gas prices going back up so that was a huge Tailwind for a lot of companies and for inflation on the on the good Goods

Inflation so that is going to go away uh second half of this year and obviously you had very easy comparisons uh against year-over-year inflation you know the fed’s getting a lot of credit for reducing inflation but in reality it’s because they did such a poor job over you know from 22 23 that

Now inflation comparatively looks looks you know oh great job it’s like it’s like my kids getting an f and then they get a d and they say wow you know the D is a lot better than F you know inflation yeah the next year makes

It a lot easier you know if you do really bad with inflation which they’ve done they’ve destroyed 20% of our purchasing power you know now all of a sudden this is good you know 4% inflation that’s that’s that’s nice but but let’s again not forget that go try

To buy a house right now you know uh pay your auto insurance bill I mean there are so many things in our life anyways that when I when I pay the bills I mean it’s like instinct now my head I just have this in I call the inflation

Headshake I’m like oh my gosh and then and then I say you go to Panera Bread and buy a sandwich with your kid and you leave and you feel like you need to take a home eony line out so um they can celebrate this inflation Victory all they want the

Reality is the middle class and the lower class have been absolutely destroyed uh they’re under a tremendous amount of pressure I’ve got one example I’ll stop because I know I’m talking too much but we have a company Monroe uh they do um auto repair and uh you know

They came out with earning their last earnings on the last earning call they’re talking about customers uh instead of buying four tires they’re buying two tires and the customers that are buying two tires you historically been buying two TI two tires are now buying one tire so you have this large

Percentage of the population that is debating whether to replace two tires or one tire you know and that’s probably half the population that doesn’t that hasn’t participated in this massive asset inflation and we have this socalled balanced economy reality what it is is half the economy is booming uh

People are just crushing and money’s coming out of their ears and the other half are just been devastated by all this inflation and for us to start cutting rates now while asset prices are record highs home prices are record highs and to somehow justify this and say you know we’re

Going have a soft Landing you’re just going to keep empowering the rich and keep you know hurting the poor uh so I think we’re in a moment where asset inflation is not the answer um but that’s where we’re going you know and and we could have a melt up here I mean

We don’t we don’t know but you’re you’re cutting rates and threatening to slow down qt in an environment that feels you know almost like 1999 so it’s to me again it goes back to you know I’m crazy this environment is just nit speaking of 1999 I don’t know

If you guys follow this closely but Reddit you guys know what Reddit is Reddit the website has gone public tick is rddt it stock is up 35% since it listed and it came out was rich when it went out I didn’t do a DCF on it because

The bottom line is a negative number which I find it’s it’s kind of hard for me to imagine how that is the case because they have this website where they just have all of these people who contribute to it for free so they’ve like their cost of creating the product

Is virtually nil and somehow it doesn’t make money but in any case it’s up 35% that’s perfect for this environment I take it it’s no longer small cap it’s 11 and a half billion what’s what’s your definition of small cap I think it came out of eight you probably

Could have snuck it in there yeah yeah so we we actually have a very wide definition uh 100 million to 10 billion so you know we want to keep as many opportunities as possible so I’ll have to I’ll have to get that symbol from you again you have to take your analyst and

Slap him around a little bit because it came out at 8 and it would have exited at 10 would have been perfect you could have just had that little 25% trade there well back back in the old days when I worked in New York you actually

Would um I would go to I was in my early mid 20s I was in my mid 20s and I would go to these Road shows I was always volunteer because IPO uh launches in New York were just like five stars was incredible and I was this broke 25y old

Kid and I would sit in this table with management and I would be eating I would be focused on the food it like I can’t believe this this is unbelievable just eating shrimp and then I would go back and tell the portfolio manager yeah buy some uh because it always went up the

IPOs always go up you know you get allocated a certain amount of shares and then they would sell them the next day you know kind of flip them uh make a profit but the IPOs I mean if you’re an analyst on the Buy or sell sign and you

Get to go to one of those lunch lunch or dinners strongly recommend that you don’t want to hold it for too long check out all those IPS from a few years ago they’re all down a touch yeah yeah you you want to definitely flip it don’t want to hold those those a trading

Sardines take your lunch and your 30% it’s late but let me let me give a quick shout out before Sor sorry JT just before I cut you off yeah got uh Toronto at Tesla Ville what’s up speaking of witch down a little bit Nashville valpariso what’s up Port

Arthur Texas Perth wa 132 a.m. that’s strong darham Jupiter congrats New Delhi SN homish County Salem Cromwell New Zealand good to have you Old Ocean Texas Brandon Mississippi Istanbul Turkey Luan Switzerland winning mesino Helsinki Kong my God Belgium Las Vegas in the house sorry

JT a I was just going to say that some of my favorite work that Eric does is bottom up like like he’s a one of the best bottomup economus so looking at the companies reading all their transcripts and earnings calls and actually faring out like what is happening from the

Bottom upwards rather than you know kind of all the economists tend to be more top down it feels like um but Eric maybe you could share some of some of the interesting findings that you’ve been noticing lately on the last uh last update that you did for that

Yeah and you know the reason we do that I’m I’m glad you brought that up because that is something I think it’s a little different um you know a lot of bottom up anal to managers they don’t have a macro view uh but we because we normalize earnings in our valuations it’s very

Important for us to understand where we are in the profit cycle you know whether you’re Peak or trough you like 2009 you’re in the trough you don’t want to use those earnings to value a company because they’re too low U and then you know I I would argue currently margins

Are so high you probably don’t want to use these margins either as a value company so we we do is we have a possible buy list of about 300 names and uh every quarter you know we read the releases and conference calls and uh come up with our macro view um and it’s

It’s you know a couple Pages kind of a summary of or highlights and it’s a little over 100 pages of notes uh but it’s kind of interesting because I think you know one of the the things we picked up on pretty quickly in in in 2021 was

Inflation uh because we were seeing it with all the with all of our companies but you weren’t seeing it yet in the um in the government data so there’s things like that I think we can pick up on in fact I wrote a blog post called

Um uh buy things you know and my whole theory was the companies are clearly communicating price increases then go out Buy buy some appliances and and U I bought I bought like three years worth of Weeden feed and I think I made like 30% on that so uh yeah so you can you

Can see a lot of things through the bottom up that you can’t really see in government data which is often you know seasonally adjusted uh massaged and usually it’s revised and it’s dated so uh you know things we’re seeing right now you know we touched on sort of the

Two economies economy one economy 2 one doing great one doing awful um I I would think that’s the the biggest theme right now of sort of the the disparity so large um and then going to the fiscal side uh a lot of cyclical companies tie to the economy uh manufacturing

Construction actually doing quite well you you have a lot of spending on you know whether it’s data centers semiconductor plants uh infrastructure across the board you know roads and bridges you know we had an asphalt company uh gen core Industries we owned for a while did very well uh but that

Was just the government flooding the system with money to pave roads so uh so that’s done well transportation’s been weak um but I think I think that’s going to change I think that’s going to pick up Energy’s been pretty good natural gas has been has been awful but but oil’s

Done so well for these companies you know that’s quite a bit higher than cost they’re doing well services Energy service has lagged um the emps just because emps have had so much more pricing uh discipline the cycle another theme that is very important that we’re seeing is companies small cap

Companies with debt uh the maturity walls are getting uh really they’re getting a little uncomfortable so some of these smaller cap companies they’re not like you know uh McDonald’s which has a lot of debt but they can still go out and issue debt and not there’s no

Issue U but these smaller companies with debt with maturity walls approaching if you even bring up like hey I might need capital the Stock’s going to get destroyed so I I think one of the things the market you know you know I don’t think markets are particularly efficient

Right now but one thing I think they have done a good job with is smaller cap companies with debt when the charity wall is approaching uh those stocks are down so if you’re going to take risk right now you know and you know the company really well and you think

They’ll survive the next recession or credit uh crunch uh I think Financial Risk is probably where I would look um fortunately we don’t have to you fully invested so we don’t have to buy a highly levered company uh to try to stay invested um but that is that’s kind of

Interesting right now we’re seeing from the bottom up I had a look at the Yad site where he splits out the PE it’s a great website if anybody’s looking for a whole lot of charts to stick into stuff but he’s got he splits out the PE multiples of large

Cap midcap and small cap and one thing that really St that to me is that large capap PE multiples have mostly expanded but midcap and small cap have definitely been contracting and I just wondered if that was the reason that you’re identifying that the small and midap

Have a lot more trouble ring that well the mark the market has done a better job in small caps because you don’t have you don’t have the flows you get the S&P you know the qqqs you know especially like foreign investors are usually not buying the small Caps or they just

Piling money into the larger Mega caps um but still I’m not saying small guys are cheap but I would say in certain areas I think the Market’s done a little better job of of penalizing companies that may have taken on too much debt through BuyBacks or Acquisitions U and

They’re not giving them a second chance and if you ask for debt you know your Stock’s going to get killed um so I I do think that’s true but but the makeup of small caps is a little different too um there’s the money losing companies which

You know haven’t done well at all the S&P for the most part is profitable companies same same with um mainly the larger caps in general are usually companies to make money but small caps are 40% money losers so uh the Market’s probably done a better job

Of beating those up if you look at just profitable small caps and maybe midcaps I don’t know it’s a little different picture where the valuations are quite a bit higher uh than they were you know I did a post that said this is not 1999 and

1999 uh well not from a large cap perspective I mean not from small perspective 9 is looking a lot like 99 from a large Cap Technology perspective but in 99 you could buy you know WD40 probably in the mid low teens multiple but now it’s 50 times but there was a a

Plethora of small cap high quality small caps you could buy 15 10 times earnings of dirt cheap so but now those same companies you know are twice three times the valuation um so quality’s done very well in small caps and that’s goes back to profitable companies um in quality

Have done a lot of well done very well and I think the reason for that is you know when things are expensive a lot of professional investors especially they they need to participate so they don’t lose assets and I think they feel if I buy quality maybe I’m not you know I’m

Kind of cheating but not really at least I’m buying some good stuff you know I remember this this manager that used to just say in his presentations he would just go franchise and you like that is like you’re forgiven doesn’t matter what you paid as long as you said franchise it’s all

Good so I think a lot of people are chasing franchise businesses now feeling safe from the business perspective but in reality I think they’re taking a tremendous amount of valuation risk which of course the price you pay is usually the the biggest determinant of of how you do yeah there’s a pretty

Pretty common refrain of you want to own quality into a recession right and that that but if everybody sort of arrives at that conclusion it gets priced in and now is that actually smart to do kind of maybe a little bit more of a question

Mark yep and and you don’t want to buy uh highly levered cyclical companies into a recession but I think in small caps anyways they’ve sniffed that out already and maybe if you had to be invested now maybe that is you want maybe you do want to buy a cal you want

To take operating risk or Financial Risk uh going into a recession which is weird or or different um but just where prices are maybe that does make more sense do you find any Industries or sectors interesting are you allowed to name names or do you do you name names you

Know the things we’ve been buying and own or have owned you know we have been selling some into this uh this Market melt up over the last few months but uh they’ve been very uh small smaller industries that you just don’t think of you know we talked about gen core the as

As asphalt plan equipment you know they own 40% of the market Shar asphalt plants uh so that’s they’re the market leader but it’s you know like a 250 million Market cab so uh and then we own the market leader in tow trucks right uh you know we own an insurance

Adjuster um we owned um a company in Canada that made uh fruit snacks and juice so uh you know some of these are not big Industries or or ones you really you know classified excluding the food company they’re just unique Industries smaller that even if they own 100% of

The market they would never be a midcap stock one of the things that stood out to me from that yardi chart that I mentioned a little while ago is that for most of the last I forget how far it goes back but it’s at least 20 years

Something like that for most of the last 20 years midcap and and small cap have traded at a premium a p multiple premium to large cap and it’s only since the pandemic that the large Cap’s P multiple has expanded Beyond I don’t know if that’s ordinarily the case or not I just

Can’t I just can’t remember but it’s it just seemed odd to me that since the pandemic it’s flipped in any case and I don’t know I I I guess the argument could be that before then you want the faster growing stuff midcap small cap grows faster so therefore the PE should

Be higher post pandemic large caps are safer financially so therefore you want you pay a higher price for that but I don’t know do do you have any given you’re a small cap guy do you have any view on on either of those FS well it’s it’s tough to use small cap

Valuations in aggregate because there’s so many things that uh affect the multiple you know we talked about money losing companies about 40% um and then you know like the Russell 2000 value huge portion of that is financials and you look at those multiples they’re very low and I don’t

Think um they’re the real multiples like I don’t think those are the real earnings if you mark to marketed the um for instance the commercial real estate loans or any of the longer data loans um you know the ones that are that are kind

Of U not you know using yeah yes yes so uh you know that actually skews the small cap multiable down considerably I mean there’s a tremendous amount of small capat banks that that that might be insolvent right now if you use Market Market to Market so uh you got to be

Careful with that energy too right now a lot of multiples are low because of where o oil prices are so you know it’s so hard to you know we get that a lot you know because some of the multiples look reasonable if you pull everything

Out you pull out the money losers um and leave in the banks and leave in some of these cycal that are doing well but if you normalize on a bottom up basis the picture looks very different so we’re always we always want to caution people to be careful with these aggregate uh

Multiples and you know sometimes people give you multiples on like fact sheets and whatnot and they won’t even explain how they derived it because if you exclude a lot of things you can make any Benchmark look interesting you know or portfolio I always thought it was funny how the Russell does that calculation

They they exclude all of the things that are uh non- Earnest and then they truncate the really high pees so the P it’s just it’s a bizarre kind of calculation that’s right yeah yeah we Jamie’s done a lot of work on that uh cuz we get that we get asked a lot you

Know a lot by clients you know if multiples are here like we someone told us small caps are 14 times earnings you know any on a normalized basis we’re not seeing anywhere near that so uh you just we would be we would recommend being careful on aggregate valuations how

Normal sorry sorry Jesse I was just going to answer the question about that kind of inversion of of multiple between small and large and I mean the the charitable version would be in my mind um you know Returns on scale and technology companies like making tons of

Money and like you know that that whole thesis playing out and maybe some truth to it my less charitable Grinchy version would be like probably the bigger the company the the closer you are to the trough of of money pouring out right cantillon effects of uh and you get the

Money before it trickles down to a smaller company right so you your margins look better you you know everyone you’re you you get the revenue before the cost inflation shows up as much so um of course then you look more profitable I would say to I think um and

Those are good points the equity comp for larger companies is quite a bit larger than many of the companies we follow so and that often gets excluded from earning so so again there a lot of exclusion a lot of exclusions out there you have Microsoft

11 billion a year I saw on on a quarterly run rate basis why why are we why are we on we should be trying to get a job at Microsoft what are we doing right and you know that doesn’t show up in earnings but it it shows up in cash

Flow when you buy back the stock so I mean I know you guys know that yeah and some of those tech companies the SBC as a percentage of free cash flow is is Extreme I mean 20 is like kind of a considered a gold standard and there’s

Lots of companies that are north of a 100% yeah and that goes back to multiples I mean most analysts will just they’ll go past all of the things that are said to be one time that occur almost every time and then they go right to the adjusted earnings and they slap a

Multiple on that and they go to lunch 2027 adjusted earnings yeah how does this how does this all play out Eric we’ve got an election this year which is presumably why there’s so much uh fiscal stimulus around I think the the the FED to some extent has been counteracting that although they seem

Like they’re as you say that they’re threatening to drop rates all the time which seems to have helped keep everything elevated six six rate Cuts this year there’s nowhere we’re few we’re through a few of the meetings so now it’s three rate Cuts this year or something like that but what do you

Think how does this play out that’s why I was that’s why I came on thought you’re going to tell me yeah I don’t know I’ve given up I think I just say the Market’s going to get down 50% at some point in the future at which point returns will be really good

But that’s my evergreen prediction that’s always true I’m going to go with that but you said sounds great um I did see that there was a guy who changed his legal name to oh yeah anybody else that’s his name literally anyone else and he and he’s running for for president and so

Win what got what if we had a new third party that’s became just from the votes of literally anybody else the funny thing about that guy is he’s he’s 35 in like one week or something like he he he waited until right he’s this is the very first time he can

Run I tell you though I mean one thing about where we are right now is I am just I’m baffled by this we have to cut rates right here it doesn’t make sense so it does make you wonder if it is political and if it is political does

This backfire because if it’s political and it sort of tilts for the Democrats well half the population doesn’t own stocks a lot of their voters don’t own homes and now you’re going to put them further behind the the wealthy I mean maybe maybe they’re going to be upset by

This the way that do you think they care when they Q goes up at percent every day I mean best steal day yeah I think I think this could backfire on them if it is political everybody gets a shave and and you know there’s so many things that

Could happen that caus this cycle to end um but one that doesn’t get a lot of talk is the uh social or the wealth inequality it it is I mean I just when we just pay our bills and things I just I just wonder you know how in the world

Can people afford to live right now um so it’s that is just making that worse to me doesn’t it’s not only not the solution which is the way they’re going I think it’s just going to get build a bigger and bigger issue down the road um I it’s just of all things not

Sustainable having half the population do very well and and really just crushing the other half it just doesn’t seem sustainable to me but it has been going on for probably longer than I expected so well unemployment close to alltime lows stock markets at all-time Highs real estate markets very you can’t

I mean housing AFF housing affordability right I mean it is um our first house I think was $250,000 and I thought we were overpaying you can never overpay in real estate not not in FL 2006 yeah well that actually was 2004 and then and then our house went up to 400,000 I couldn’t

Believe it we sold and then we rented for two years waited for the bus and then we bought so we actually day traded the home or two years but uh so that worked out really well and then I’m like well do we do it now because now our

House is worth this stupid amount again uh for no reason except you know asset inflation but the difference today is uh you know it’s well we have kids now so makes it a lot harder but you know the uh cost to rent is significantly higher you know that so that renting equation

Doesn’t work as well uh or that variable and um you know I I just I feel this cycle I want to have part of our cost of living locked in like I don’t trust the fed you know in 06 07 or 06 when we sold

I didn’t QB wasn’t a thing I think if you sell in rent now you’re you’re taking more risk in that the next uh recession or crisis you know they print another 5 trillion and now you’re in an apartment you know with kids and your wife and they’re like what’s

Up I thought we were going to beion by now yeah you’re priced out I wish we were in our house so it’s it’s a lot trickier it’s tempting for sure to take those gains but but everything is so expensive now it’s hard the Arbitrage is

A lot different now than it was in 056 in 06 you could sell your house and rent and take the proceeds and put it in a 5% CD and it almost paid for your rent you know it was wonderful you can’t do that now because rents are so

High shall we uh get some veggies under the wire before to late veggies yeah you know I try when I’m at my best to uh match up the veggies along with the guest and you know as I mentioned before that Eric is to me one of the great

Bottomup economists out there um coming through all these earnings transcripts and then offering these kind of real-time insights that that happened before uh they show up in official statistics but it kind of got me thinking about this other fellow who made predictions about what it would be like if we could

Measure everything and his name was Pierre Simon llas and he was a French scholar in polymath and he lived from 1749 to 1827 and he made important contributions to engineering mathematics statistics physics astronomy uh he has his name on a few equations which is always about as

Big as it gets right if you can get your name on something uh and uh one of them is in the field of like partial differential equations don’t ask me to tell you what that is uh but apparently they use it for describing like title flows and he was also the first to

Predict the existence of black holes um and 1814 he set out a mathematical system of inductive reasoning that’s that’s based on probability which today we would probably recognize as like basian statistics so anyway today we’re going to be discussing this thought experiment that he had called lasses

Demon and it’s an exercise in kind of causal determination and and it goes as follows imagine that there’s a demon which knows the precise location and momentum of every atom in the universe and their past and future values for any given time it could then be calculated and predicted with perfect accuracy so

Basically and by the way llas never used the term demon in any of his writing it was just added later for embellishment uh by others but what if you could measure every single little absolute detail and then could you ACC accurately predict the future at that point and

This is I think kind of a an interesting thing to think about AI then and and as we’re trying to measure everything using AI can AI do predictions that that are better than you know does can it measure every little atom in the universe effectively uh now there are four

Arguments in against lass’s demon uh in the physics realm number one is entropy uh ll’s demon was basically vanquished with the Discover of discovery of irreversibility and and entropy uh the second law thermodynamics like it’s based on the premise that that there is reversibility but many thermodynamic processes are irreversible so imagine

Like you stir a cup of coffee with cream in it like you know you can’t really un you can’t get the the the cream to be uh unstirred ever uh at that point um there’s also the the problem of quantum indeterminacy and like this is basically like Heisenberg’s uncertainty principle

There’s there’s properties like position and momentum which you can’t know both at the same time um and then there’s chaos theory and like the sensitivity to initial starting conditions so you know this is kind of like the classic Butterfly Effect where small changes produce these huge in inaccuracies and

Predictions um this one’s a little bit less convincing because the premise of lass’s demon is that you know every initial condition with perfect accuracy and then the last one is is computational complexity there was uh recently some work uh that had a proposed limit on the computation power

Of the universe so and this is um you know imagine the limit is based on like the maximum entropy of the universe using the speed of light the minimum amount of time taken for information to move across the plank length uh and then and it’s been shown to be about uh 10 to

120 power bits um so basically like there’s it would be there’s so much uh it would require so much computational power to ever figure this out that like the amount of time that’s ellp eclipsed in in the last you know since the universe started is not enough to ever

Really do it so but let’s think a little bit about lass’s demon and AI because it’s kind of an interesting topic right now um you know AI has the same problems of trying to predict outcomes Based on data like what is known today what is going to happen tomorrow uh and in this

Context like it’s kind of a useful metaphor um you know the AI is trying to predict future events uh and if it had complete information maybe it could but it’s never going to have there’s always fundamental limits to how much information you can actually have um and

AI faces that same type of constraint um there’s also the the quality and the quantity of data that the AI is trained on so you know in that way that sort of mirrors the impossibility of of lass’s demon having complete knowledge uh and then there’s some like ethical considerations actually just like lass’s

Demon raises questions about it really like Free Will around you know like you know judicial sentencing loan approvals recruitment like you know if you’re using AI for some of these things like there are these biases that can can be baked into the AI based on the training

Data um and you know if an if an AI is that good at predicting individual human behavior like what does that imply then sort of for like personal responsibility and Free Will um and then the last one is is kind of omniscience and control uh the idea that if if an enti could

Predict every future event you know what like what kind of surveillance then would be required like you almost start to run into like Minority Report you know the sci-fi movie with Tom Cruz um that you know predicting murders and things like that um so what does that

Mean then for privacy and autonomy and control of of government so uh hopefully there’s a little bit of maybe thinking through some of lass’s demons and and the implications of that from a physics context that we can then apply to AI to help us give us some kind of

Metaphorical framework to to explore the capabilities and limitations of AI what about natural intelligence does that suffer from those same limitations of course so yes of course more inconsistent true you know on the uh on the ethical side this is inter or timely uh my daughter’s English class had a

Essay assignment and they discovered half of the students used AI to write it how did they discover and the teachers now are using AI to find Ai and so you know this is going to be an issue for the academic world um because half the class decided it was a

Lot easier to just to have ai right through that say and the other half did it so uh it’s it’s you know that’s just one example but there’s going to be a lot of ethical issues how do we pivot back to to investing JT you Le plan uh oh boy

Um I guess Eric if if uh do you think that if how how well do you think a a a model could do if you gave it all of the data that you collect on a bottomup basis from these individual companies do you think that there’s more insights to be gleaned from

There or would it start tipping into absurdities you know I just I have trouble thinking a um computer can accurately predict the cyclicality of these businesses I mean there’s there’s so many variables that can affect margins and they all move different ways at different times and a

Lot of it’s based on human behavior so I I reluctant to uh to feel uh confident of evaluation spit out by an AI model um you know kind of the in the data going in you know is that accurate you know is it smooth is it we talked about the

Multiples being kind of you know not really accurate in some cases so uh when you look at an operating margin of a business every quarter uh there just so many things that that can make it go one way or the other that are um I don’t

Know maybe maybe we do need AI because my my mind is having a hard time comprehending this do you find do you find it helpful do you find it helpful for hunting for ideas to to kind of look through is is that is that why you do it

To look through Industries and look through them at that level just you’re looking for you know some something that might be depressed but showing signs of life or or is it to help normalize for the companies that you’re modeling yeah it’s it’s it’s more for normalized but

And we we follow a lot of the same companies you know that we followed 20 years ago so there’s there’s always so many mature Market leaders and small caps and that hasn’t changed over many years so uh you know if if like I hate using I always use this but I’m using it

Anyways oil drives the market leader and cat litter one of the market leaders and it was founded in the 60s I’m very confident it will be the market leader one of the market leaders in 10 years from now I’m very confident many of the variables that drive the earnings will

Be around you know be similar so uh for us a lot of it too is familiarity you know we have 300 names we know them well uh so we follow the same ones and some get bought out you know and the name will come on the list the name will come off

But over time just following the same things uh knowing something really well uh I think provides a really good Advantage uh because you know when Co hit you know and small caps fell 40% we didn’t have to to uh do screens you know it was it was immediate we we had ideas

We had we were buying immediately and uh because we we had familiarity with the names we knew it was was affecting margins and we had a good idea what normalized were so uh yeah I don’t know if AI can recreate that I mean if it could um I guess we’re done well or

Maybe AI would allow you to keep a a larger inventory of of ideas on the Shelf then yeah or or it could alert you to hey uh this is trading below normalized or the profits are above normalized profits are below and it could it could maybe help you with your

Screening you know where should I look you know think that might it might be more useful that way for us over time but um that’s going to be tough you know for us to transit or at least for me because how I’ve done things for 30

Years you know I admit that would be hard the criticisms of the small cap indexes has been that there’s a deterioration in the quality of small caps because for a variety of reasons one it’s more costly to be listed so some companies just stay private stay with private Equity get get handed back

And forth between private equity yeah and other companies like Facebook they wait until they’re huge before they come on the boards maybe even Reddit like it comes on at 8 billion where previously they might have listed as smaller companies and work their way through those indexes and graduated into midcap

Or large cap indexes does that have you found that is that your experience or something else um yeah I think the you know I’ve been doing this since 1993 and I I definitely think the quality has declined um you could see that with the percentage of companies that lose money

But that’s somewhat cyclical I mean here we are you know in a booming kind of profit environment uh and you still have 40% of companies losing money you know so that because they’ve never they’ve never they’ve never made money they just they raise capital and they they burn it

Yeah and I mean the last IPO boom we had a lot of them were spacks right I mean yeah so those weren’t they weren’t they weren’t they weren’t making or losing money they just were giving money you know so that was odd um but we usually

Don’t buy a lot of IPOs because we buy more mature businesses that have been around a long time we have a long operating history but some of these IPOs do you know but by now uh if you’re a market leader mature business you probably already gotten bought out you

Know there’s there’s not a lot left ready to go you know that kind of business that are ready to go public like you said there’s there’s a lot of reason now probably it’s not worth it especially if you don’t need capital and if you need Capital that’s EAS not not

The type of company we’re interested in uh Eric we’re coming up on time if uh folks want to follow along with what you’re doing and get in touch how do they do that uh Palm valy capital.com is our website and uh we have a a Blog and uh

Every quarter Jamie writes her letters which are very good and um you know come come uh to our website and if you like our content that’s awesome and if not you know we understand little different so uh but we appreciate your interest uh in your time guys Jake and Toby really

Appreciate you having me on I’ll put in a plug that Eric’s blog is one of the one of the very few blogs that I read regularly pretty much anytime he puts something I’ll read it within uh 20 minutes Jake that’s because it’s under a thousand words

Right that’s not that’s not a bad thing doesn’t hurt Eric cinnamon thank you very much folks we’ll be back next week same bat Channel same bat time see you