Many investors regard small-cap stocks as highly volatile
growth plays, but this broad category is far more variegated than
this stereotype would suggest. We recently spoke with Eric
Cinnamond, manager of
Intrepid Small Cap (
), whose stock-picking acumen propelled the fund to the top of
Morningstar's Small Value category in 2007 and 2008. Here Eric
discusses his investment strategy and the dangers of judging a
small-cap stock by its classification.
What's your strategy when it comes to equities selection?
We take a bottom-up approach to investing that emphasizes
fundamental analysis and valuation work, but we don't use sell-side
research. We focus on absolute returns and don't worry about
benchmarks and sector weights, which makes us a bit more flexible
than the typical fund and allows us to gravitate to whatever names
We evaluate stocks by discounting free cash flow, though we
value the assets of energy firms, financial companies and other
asset-heavy businesses. We tend to focus on established companies
that generate a lot of cash and have weathered a lot of economic
cycles, qualities that enable us to have a high degree of
confidence in our valuations. We find that if you keep the ball on
the fairway you tend to do much better than swinging for the
fences; we don't hit a lot of homeruns, but we also don't strike
out a lot.
We generate our returns through a thoughtful, slow-and-steady
type of investment strategy that isn't overly complicated--though
it can be hard to stick to, especially during speculative periods.
Back in 2007 leveraged-buyout firms were paying outrageous prices
for mundane businesses, extrapolating crazy earnings growth or
extremely low financial costs over a long period. Of course, that
approach backfired in late 2008.
Speaking of hysteria, there was a huge run in small-cap
stocks through much of 2009. What drove that?
Small-cap stocks traded at incredibly low values in March 2009,
when the Russell 3000 sank to roughly 350 from a peak of 850. At
that time, we found a boatload of good values because many
investors acted as though the economy were dead and would never to
operate again. Given the degree of overreaction on the downside, a
lot of the rebound struck us as quite rational--a return to fair
value. Today small-cap stocks trade at fair value, though some
segments may be slightly overvalued. We're still finding
opportunities, but it's definitely not as easy as it was.
I think speculation is definitely the culprit if stock prices
head 20 to 30 percent higher from current levels. Market cycles are
so compressed, and memories are getting shorter and shorter--you
had the tech bubble, the housing bubble and oil at USD140--so I
wouldn't rule out another speculative period. And I think investors
are almost conditioned to expect another bubble; given the
prevalence of the word these days, it's seemingly a permanent
feature of the new landscape.
Although the stocks that we choose to include in our portfolio
are a big part of the fund's success, it's important to remember
that selectivity also implies avoiding certain stocks or
We steered clear of banks and didn't have any energy or cyclical
companies in mid-2008, when that group was in vogue. Then energy
names made up almost 23 percent of the portfolio at one point in
late 2008; we had moved into cyclical names because those were
getting hit the hardest and that's where we were finding value.
Uncharacteristically, we also found value in companies with debt--a
quality we typically avoid. These were ideas we usually wouldn't
pursue, but the discounts were so large we thought the potential
upside was worthwhile.
That being said, when we buy energy companies or stocks issued
by companies with debt, we never take on operating and financial
risk at the same time.
We built a stake in an energy company called
), which has no debt net of cash. This limited financial risk was
offset by operating risk; Tidewater's business is relatively
volatile, and its stream of cash flow can range between USD2 and
On the other side, we bought
), the market leader in wine. Constellation has some debt exposure,
but US wine consumption is growing 2 to 3 percent per year. In this
instance, the financial risk is offset by the steady nature of the
Higher-risk cyclical names have rallied the most this year, and
we've recently sold those that hit our valuation targets. Our most
recent ideas have been in line with our long-term strategy of
investing in companies that boast a strong balance sheet, generate
ample free cash flow and operate in relatively stable end
markets--boring stuff, but it works.
Your portfolio features a lot stocks that are typically
classified as early-cycle investments. What's your take on the
recovery and its sustainability?
A lot of small caps are in unique industries and don't really
fit neatly into a classification scheme. One of the stocks we own
Oil-Dri Corp of America
), which falls into the consumer discretionary or industrial
category. One could also argue that it's a mining company. The firm
mines clay, dries it, and then processes it into cat litter. To me,
that's a consumer staple. I have a cat and, believe me, you have to
buy cat litter; you will not like the results if you replace it
with paper litter.
) is one discretionary name that continues to generate quite a bit
of cash. It's slowed its growth from 100 stores a year to 40
stores, transforming itself into a cash cow rather than a growth
company. But the specialty retailer's comparable sales have
remained positive--hardly what one would expect from a
Another example is
Core-Mark Holding Company
), the second-largest distributor to convenience stores. Over the
past 10 years it has grown sales to convenience stores over 7
percent annually. Nevertheless, it's often categorized as a
transportation company--even though it lacks the high capital
expenditures and volatile day rates and utilization that are part
and parcel to that business segment. It's not as risky as the
transportation label would suggest.
Our investments in the energy patch are another case where
there's more than meets the eye. Because we focus on companies with
the strongest balance sheets, our holdings are less volatile than
other names with levered balance sheets. Regardless of where we are
in the economic cycle, Tidewater will continue its steady
performance and its long-lived assets will only increase in value.
We always lean toward lower-risk plays, but sometimes an industry
pie chart doesn't capture that lower risk portfolio.
Because of our efforts to limit risk while generating total
returns, the fund has posted a negative annual return on only one
occasion: The market turmoil of 2008 resulted in a 7 percent loss.
Of course, this approach also limits our upside. If the markets
were to go up 20 to 30 percent, I would expect our fund to lag.
However, thus far in 2009 we've outperformed, which is unusual for
us; because so many high-quality names traded at a discount, we
were more aggressive than usual in our investments.
The fund is still extremely light on banks. Is there just
not any value there?
I recently bought my first bank stock in about five years when I
). It's got no subprime exposure and had equity to assets of around
Despite having loads of capital, they participated in the
Treasury Dept's Troubled Asset Relief Program to establish their
strength; once management realized that participation in the
bailout wasn't necessarily a sign of health, the bank quickly
repaid the government. Washington Federal was one of the first
banks to tell the truth about its book of business, quickly
classifying loans as nonperforming. This high number of
nonperforming loans has declined fairly quickly.
The banks I'm skeptical of are the ones with low loan losses and
low loan-loss provisions; I just don't believe them. The banks are
so hard to value because they lump so many assets under one
category that it's really hard to decipher the quality of their
What's your best advice for investors over the next
Be careful, the time to take risk was 6 to twelve months ago.
Patience is the most important virtue for successful investors.
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