<September 2, 2021>
People often say it’s the small things in life that matter most. Whether it’s that first sip of an early morning beverage, or a cool late afternoon summer breeze; take it in and enjoy. I have a long list of small things I enjoy, ranging from the soft feel of bedsheets right out the dryer to the smell of a freshly cut lawn. One of my favorite small pleasures in life is putting on a pair of new running shoes. Oh yeah, the comfort and feel—it doesn’t get much better than that!
As running shoes age, their feel and comfort gradually deteriorate. It’s a natural part of a shoe’s life—transforming from new to mature. It happens to all of us! At some point it’s time to say good-bye and buy new shoes. However, since most old running shoes are still functional, I’ve always had trouble saying good-bye. In fact, to my wife’s displeasure, I’ve accumulated several years of old running shoes in a closet in our garage. You never know when you might need a pair of used and dependable running shoes!
Our closet full of old running shoes reminds me of Palm Valley’s 300-name possible buy list. Mature and highly functionable businesses we’re familiar with that we refuse to throw away. It has taken many years and economic cycles, but over time, we believe we’ve gotten to know the companies on our possible buy list well.
Getting to know businesses isn’t too different than getting to know people. Businesses have their own personalities and unique traits, with some being more desirable than others. Like people, businesses can also provide misleading first impressions. As such, to truly know a business it may take years, or an entire economic cycle, before thoroughly understanding its character and peculiarities. After following a business for years, and in some cases decades, it becomes like an old friend—there are few things you don’t know. And similar to friends, as time with a business grows, its behavior becomes more predictable, limiting surprises and disappointments.
We believe familiarity is a significant competitive advantage when allocating capital. In our opinion, by focusing on a relatively fixed opportunity set, we’re better able to accurately value a business and limit mistakes. In effect, we know what we’re getting into when buying a business that we’ve followed for many years. Further, as the prices of our opportunity set fluctuate—sometimes violently—we believe familiarity improves our ability to act opportunistically and decisively.
During the first quarter of 2020, when the Russell 2000 Value declined 45% from its highs, we turned to our buy list for potential ideas. Since we were already familiar with the businesses and their valuations, we were able to quickly take advantage of sharply lower small cap prices. Within a few weeks, we purchased 20 new equity positions, with 17 coming directly from our possible buy list. When Jayme and I discussed each idea, we were already familiar with the businesses and what we believed they were worth. Familiarity made our decision process easy, and in hindsight, effective.
Our possible buy list is populated with a variety of businesses in numerous industries. We know which companies provide valuable insight and which companies are known for spinning almost everything sunny side up! We follow companies managed by engineers, marketers, and accountants. They all have their own tendencies and styles of communication. And since most of the companies we follow are smaller, we’ve found they tend to talk more freely than their larger counterparts. For example, one of our favorite CEOs, who is never shy about speaking his mind, is Park Aerospace’s (symbol: PKE) Brian Shore. During Park’s last conference call, Mr. Shore went a little off script and provided listeners with a refreshing missive on money, hard work, and sacrifice. We enjoyed it so much we thought we’d share it with you.
“Strange days have found us. I think that's from The Doors. People are getting paid not to work. Free money being force-fed into the system. In the old days, people believed work was something honored and valued. It gave a person self-respect, self-reliance, dignity. But now maybe not. Free money. It used to be that you worked hard, you sacrificed, you were frugal with your money. And one day…you'd be able to use that hard-earned money because it had some real value. But now just use it, cheap and easy money. If it doesn't work out, it doesn't really matter because it never was really your money anyway. So it's kind of sad actually. Why bother to work hard and sacrifice because -- why do that? Why not just tap into the cheap and easy money. It's kind of tragic, in our opinion. But the world, like I said -- the world seems upside down and backwards to us. What was supposed to matter, doesn't. What was not supposed to matter, does.”
After reading Mr. Shore’s commentary, we’re reminded of how “free money” has affected the operating results of the companies we follow. Whether it’s elevated sales at retailers or depressed loan losses at banks, easy money has undoubtedly inflated corporate profitability. We saw this again in the most recent round of earnings reports and conference calls.
As a reminder, every quarter we aggregate the operating results of the businesses we follow to determine current economic trends. In effect, it’s a timely macro update based on actual business results, outlooks, and management commentary. It’s not too dissimilar from the Fed’s Beige book, which attempts to gather information on current economic conditions through its business contacts.
So, what is Palm Valley’s Beige Book currently telling us? We provide a summary below:
Overall, the first half of 2021 was strong. Business trends accelerated while most outlooks for the second half of 2021 improved. Management tones were optimistic and self-congratulatory.
While Q3 2021 is also expected to be robust, comparisons for many consumer businesses are becoming increasingly difficult.
Government stimulus continues to be mentioned as a demand catalyst; however, few are able or willing to quantify. Businesses that focus on the less affluent performed particularly well. Large ticket items, average basket, and ticket growth remain elevated, suggesting the more affluent continue to spend as well.
Profits were enhanced by COVID-19 expense reductions that have yet to be fully reinstated. This should contribute to difficult profit comparisons going forward as expenses return and companies attempt to become more fully staffed.
Labor shortages are a growing issue for many businesses. Wage inflation and incentives remain on the rise.
Inflation remains a dominant theme with many costs rising sharply and broadly. Rising freight, packaging, insurance, commodities, and labor expenses were all mentioned. Supply (material, parts, and labor) constraints continue and were mentioned frequently. Some companies noted they expect supply to improve later in the year while others believe it will spill over into 2022.
Price increases are higher and more frequent than normal with price increases being accepted relatively easily. Price increases do not appear transitory, spilling over into the second half of 2021 and first half of 2022. Many price increases have been announced but have yet to go into effect. Promotions continue to be below average, increasing average selling prices.
Transportation capacity is very tight and is not meeting demand. Bottlenecks, insufficient equipment, and labor were noted.
Inventories have improved, but remain low with several companies reporting lost sales due to insufficient product. Replenishment of inventories is expected to aid transportation demand for the remainder of the year.
Industrial businesses showed a noticeable uptick—playing catch-up with consumer businesses.
Housing remains very strong with pricing up considerably as home builders choose maximizing profits over ramping up supply. Residential construction continues to grow faster than commercial; however, several companies noted commercial construction and renovations are improving.
Banks and financials are doing well overall with rapid deposit growth, slow to moderate loan growth, and low loss ratios. The reach for yield (especially CRE loan growth) continues. Insurance companies are benefiting from higher premiums/pricing power and rising financial asset prices.
Energy exploration and production companies (E&Ps) remain disciplined, which is helping keep production growth in check. As a result, energy service firms are not faring as well as the producers. Unlike past energy booms, it appears the E&Ps will be the cash cows this cycle, not the energy service companies.
While we acknowledge business operating results are robust, we do not subscribe to the commonly held belief that this makes equities attractive investments. In fact, we believe the opposite. Current operating results, and the response by investors, reminds us of 1999 and 2006. Similar to those peaks in the economy and market, we believe investors are currently extrapolating exceptionally strong operating results far into the future. In fact, based on current equity valuations, we believe extrapolation risk has never been higher. The only thing investors do not appear to be extrapolating is inflation, which ironically is the most dominant and persistent trend businesses are experiencing!
Instead of extrapolating, we prefer normalizing. And based on our normalized margins and free cash flow estimates, we continue to believe our opportunity set has never been more expensive.
During the next bear market (yes, we still believe in those!) we’re optimistic our familiarity with our possible buy list will pay dividends. Even with small cap valuations reaching heights we never imagined, we’ve remained committed to staying up to speed on hundreds of potential buy ideas. We’re confident our preparedness will allow us to act decisively once volatility and genuine opportunities reappear. In summary, our recycle bin is full of highly functional high-quality small cap stocks that we believe will fit perfectly in our absolute return portfolio. In our opinion, it’s only a matter of time before we’ll be wearing many of these names again.
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.
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The Palm Valley Capital Fund is distributed by Quasar Distributors, LLC.
Definitions:
Market Cycle: A market cycle is a period of time that consists of both a bull and a bear market.
Russell 2000 Value: Russell 2000 Value Index refers to a composite of small cap companies located in the United States that also exhibit a value probability. The Russell 2000 Value is published and maintained by FTSE Russell.
Russell 2000: The Russell 2000 index measures the performance of the 2,000 smaller companies that are included in the Russell 3000 Index, which is made up of nearly all U.S. stocks.
CRE: Commercial real estate
Free cash flow: The cash generated from operating a business minus cash expenditures. It is often calculated as net income plus depreciation and amortization, less changes in working capital, less capital expenditures.
EV/EBIT: A ratio that compares a company’s enterprise value (EV) to its earnings before interest and taxes (EBIT). EV/EBIT is commonly used as a valuation metric to compare the relative value of different businesses.