Eric Cinnamond has been called “the godfather of small cap absolute return investing.” From 1998 to 2016 he ran an equity investment strategy that handily beat the 8% average annual return of the Russell 2000 Index. But what’s even more impressive is he did this while holding an average cash allocation of about 40% so his equity performance was roughly double that of the index.
In this episode we discuss his background and his evolution as an investor. We also delve into his current process which entails his close study of roughly 300 companies. He reveals how he looks at business valuation and how he evaluates risk in that context. We also get into the current market environment and talk about how his discipline requires that he take an extreme contrarian position today both with his investments and his career.
Below are a few links related to the episode:
- Eric blogs regularly at EricCinnamond.com where you can also sign up for his email newsletter.
- He also recently wrote an in depth piece for Value Investor Insight that I highly recommend.
- Header image via Barron’s profile of Eric.
I asked Eric to share a bit more about his valuation process and discounted cash flow analysis. This was his response via email:
On my DCF model, it’s embarrassingly simple. Because I normalized my free cash flow assumption, I don’t attempt to guess years 1 through 10 or 20 and then apply a terminal value. I learned long ago estimating cash flow several years out is very difficult. Instead, I simply start with a normalized cash flow and do terminal value from year one.
For example, most of my valuations are calculated using the following formula: Normalized Free Cash Flow/(required rate of return – growth rate). My required rate of return is usually 10-15%. This is the return I’m attempting to achieve on my equity investments. People often ask, if you don’t focus on the benchmarks, what’s your ultimate goal? My goal is to achieve an adequate absolute return on my equities. So if I achieve my goal I should be achieving a 10-15% equity return, which I have through 1998-2016.
My required rate of return does not rely on risk-free rates, unlike most valuation models. Instead I ask what would I demand as a lender to the business (often 6-8% for small cap companies) and then I apply a risk premium on top of that (usually 4-6%). It’s subjective, but has worked for me over time…and has always made more sense to me than using risk free rates.
My growth rate is less than you’d think for small cap businesses as most of the companies I follow are mature companies in mature industries. Normally I use a 2-5% growth rate.
Sorry this is so long…just wanted to get to an example with the above in mind. I like to use Oil Dri (ODC) as an example because it’s such a simple business to value and understand (cat litter). Given their strong balance sheet and historically consistent cash flows/end market, I use an 11% required rate of return (7% debt + 4% equity risk premium). It’s a below average risk business, so I use a below average discount rate (low end of 10-15% range). The last time I did a valuation on ODC, I came up with $13 million in normalized free cash flow.
Most of my free cash flow assumptions are really based on a normalized operating margin assumption (what do I believe the average margin will be over a complete profit cycle). Off the top of my head I believe I used 7-8% for ODC. Finally, I use a 4% growth rate. 3% for their core business and 5% for their commercial business that has shown more growth and potential growth (they do a lot of animal health business and purification — both businesses use their clay resources).
ODC Valuation $13 million normalized fcf/(11% discount rate – 4% growth rate) = $186 million/7.1 million shares out = $26/share. The stock is around $35. It’s very similar to valuing a perpetual bond which is CF/discount rate.
So it’s not a complex DCF model. It’s more of a valuation you’d expect from a bond analyst. Which makes more sense to me as these are mature businesses that I expect to generate long-term cash flows over many years.
Again, sorry this is so long, but thought it would be helpful in explaining my valuation technique. About 2/3rds of my valuations are done by DCF. The other third is based on asset valuation. Where I’m trying to buy a balance sheet at a discount to NAV. This is how I approached the miners. We can go over this another time, or another podcast, but I think you’ll find it different and interesting as well (makes a lot more sense to me than EBITDA valuations on asset heavy companies, which has never made sense to me).
I’ll stop here before I inadvertently write a book!
