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  • Writer's pictureEric Cinnamond

The Economics of Different

<May 29, 2024>



I grew up in a small town outside of Louisville, Kentucky. I’m not even sure I’d call it a town – more like a zip code. We lived in a subdivision with five acre lots and gravel roads. Growing up on a gravel road had its challenges. Falling off your bike was painful! Walking or running on gravel can also be uncomfortable, with rocks often finding their way into your shoes. Dust is an issue too, along with bumpy rides and potholes. But there were some benefits.


As kids waiting for the school bus, we played a game that consisted of throwing rocks at a street sign. It was a simple and fun game. How many times could we hit the sign before the bus arrived? The street sign was long, but narrow – it was a tough shot. Hitting the sign before getting on the bus was always a nice way to start the day!


I thought of my old bus stop this morning after driving past a group of kids waiting for their school bus. Instead of playing games or throwing rocks, they were staring down at their phones. No one was moving or saying a word – they were frozen. What were they so focused on? Were they reading Palm Valley’s latest quarterly letter? I wasn’t sure, but it really made me appreciate my childhood and growing up on that old gravel road.


Whether throwing rocks at signs or gazing into their phones, kids tend to do what other kids are doing. Little changes as we get older. In past posts, we discussed how career risk and groupthink can influence investor behavior. The investment management industry is not alone in its tendency to conform. Look at every industry and you’ll often find companies mimicking and following each other. Whether it relates to compensation, acquisitions, buybacks, social posturing, and general corporate strategy, most companies herd together and think alike.


The energy industry is a good example. I’ve been following the energy industry closely since 1996. When I began researching the sector, I quickly learned that if you know what one energy company is doing, you can be confident the entire industry is doing the same thing. For instance, in 2006-2008 natural gas prices were elevated and the shale revolution was picking up steam. The industry was enthusiastically buying and drilling natural gas properties. Although two consecutive cold winters delayed the inevitable, the supply of natural gas eventually spiked, and prices fell. Suddenly spending heavily on natural gas properties no longer looked appealing.



In 2011-2014, as natural gas prices remained depressed, the price of oil was elevated, trading above $90 per barrel for most of the period. In response, the energy industry moved together again, sharply curtailing natural gas exploration in favor of oil. As natural gas projects were abandoned, the industry rushed into oil rich basins such as the Bakken and Permian. Acquisition and acreage prices soared. Similar to the natural gas boom, the rush to drill oil eventually caused production and supply to rise, which contributed to a sharp decline in oil prices in 2015-2016. With oil prices falling, the energy industry responded in unison again, abandoning growth plans and selling assets and equity at depressed prices.


Imagine for a moment an energy company that acted differently during these years. What if this imaginary energy company didn’t aggressively grow production and buy new properties during the industry’s boom? What if this company didn’t take on considerable debt like its peers? Instead of using its cash flow to buy new properties when prices were high, what if this company allowed cash to accumulate on its balance sheet? Instead of selling assets and issuing equity near the industry’s trough, our imaginary energy company used its strong balance sheet to opportunistically purchase distressed assets during the industry’s bust. In effect, what if our energy company didn’t conform and did the opposite of its peers? We suspect it would have created tremendous value for its owners.


The energy and investment management industries have a lot in common. Both industries are highly cyclical, with long histories of extreme booms and busts. Participants in both industries also tend to allocate capital based on unsustainable trends – extrapolation risk is elevated. When cyclical trends inevitably reverse, both industries can experience similar dislocations. For example, a decline in equity valuations (pick your favorite cyclically adjusted P/E ratio) from 30x to 15x wouldn’t be too dissimilar from oil falling from $100 to $50. In our opinion, investors currently paying over 30x normalized earnings for equities are no different than energy companies aggressively buying oil properties in 2011-2014 and extrapolating $100 oil.



Similar to our imaginary energy company, let’s now imagine an investment management firm that refused to conform and invested differently. Instead of firing its active managers and replacing them with passive funds, the firm encouraged independent thinking and uncorrelated positioning. Instead of hugging a benchmark and remaining fully invested during periods of record high valuations, the firm invested in a flexible manner that allowed its managers to sidestep losses and take advantage of future opportunities. What if there was an imaginary investment management firm that was willing to underperform and lose clients if that’s what it took to remain disciplined? Like our imaginary energy company, we believe this asset management company would be in good shape over a full market cycle.


Although going against industry trends can be rewarding, it’s not easy. This is particularly true for the asset management industry when price trends feel irreversible, and conformity is being rewarded. With investors piling into passive strategies and chasing many of the best performing stocks, the current bull market in conformity appears invincible. For the remaining active managers, investing differently at this stage of the market cycle can be a career killer. Nevertheless, given valuations and the drivers of the current cycle, we believe the economics of different have rarely been more attractive.  


Eric Cinnamond

 


The Palm Valley Capital Fund can be purchased directly from U.S. Bank or through these fund platforms.


Index performance is not indicative of a fund’s performance. It is not possible to invest directly in an index. Past performance does not guarantee future results. Current performance of the Fund can be obtained by calling 904-747-2345.

 

There is no guarantee that a particular investment strategy will be successful. Opinions expressed are subject to change at any time, are not guaranteed, and should not be considered investment advice.


Fund holdings and allocations are subject to change and are not recommendations to buy or sell any security. Current and future portfolio holdings are subject to risk. Click here for the fund’s Top 10 holdings. 


Mutual fund investing involves risk. Principal loss is possible. The Palm Valley Capital Fund invests in smaller sized companies, which involve additional risks such as limited liquidity and greater volatility than large capitalization companies. The ability of the Fund to meet its investment objective may be limited to the extent it holds assets in cash (or cash equivalents) or is otherwise uninvested.


Before investing in the Palm Valley Capital Fund, you should carefully consider the Fund’s investment objectives, risks, charges, and expenses. The Prospectus contains this and other important information and it may be obtained by calling 904 -747-2345. Please read the Prospectus carefully before investing.


The Palm Valley Capital Fund is distributed by Quasar Distributors, LLC.

 

Definitions:

CAPE ratio (Shiller P/E): A valuation measure that uses real earnings per share (EPS) over a 10-year period to smooth out fluctuations in corporate profits that occur over different periods of a business cycle. The CAPE ratio, using the acronym for cyclically adjusted price-to-earnings ratio, was popularized by Yale University professor Robert Shiller. It is also known as the Shiller P/E ratio.

WTI: West Texas Intermediate (WTI) is a grade of crude oil and one of the main three benchmarks in oil pricing, along with Brent and Dubai Crude. WTI is considered a high-quality oil that is relatively easy to refine.

MCF: an abbreviation derived from the Roman numeral M for one thousand, put together with cubic feet (CF) to measure a quantity of natural gas.

 

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