Eric Cinnamond on small cap value, inflation, tariffs, deficits, Mag 7, and AI cap ex | S07 E27
Summary
Small Cap Value: The guest highlights multi-year underperformance, negative flows, and dispersion in margins creating a compelling setup for disciplined small-cap value with an absolute-return tilt.
Recessionary Cyclicals: Strategy centers on buying businesses already in recession with stabilizing fundamentals and solid balance sheets, favoring names where earnings are depressed.
Heartland Express (HTLD): Trucking remains in a multi-year downturn; HTLD is intentionally shrinking fleet, limiting capex, and generating about $120M free cash flow on a ~$600M market cap.
Monro (MNRO): Auto repair chain is closing stores, maintaining a 6%+ dividend, and generating cash despite consumer deferrals; recent comps turned positive, offering cyclical recovery optionality.
Energy E&Ps: Select E&Ps look attractive at or below reserve replacement cost with improved capital discipline, dividends, and buybacks, though balance sheet quality remains a key filter.
AI Infrastructure: Massive capex resembles 1999-like exuberance with uncertain ROI and rapid chip obsolescence, warranting caution on long-dated tech cash flow assumptions.
Tariff Inflation: Companies plan to pass tariffs via price hikes, supply-chain push-through, cost cuts, and product re-engineering, implying higher goods inflation into 2026 and potential job impacts.
Premiumization: Firms are skewing offerings toward higher-income consumers (e.g., premium airline seating), while affordability pressures weigh on lower-end demand and discretionary spending.
Transcript
I think we're live. This is Value After Hours. I am Tobias Carile, joined as always by my co-host Jake Taylor. Our special guest today is Eric Cinnamon. We've had him on before. He's a small cap value specialist and his firm is Palm Valley Capital Management. How are you, Eric? Welcome. >> Hey, Toby. Great to see you. Jake, >> always good to speak with you. >> Yeah. >> How is Small Cap Value doing? >> Awesome. Incredible. Um, >> objection leading the witness. >> I mean, there's no better place to be than active small cap value. >> And then you you sprinkle on the absolute return tilt. And um, yeah, things couldn't be better. Just it's uh, >> well, there's two things. What's the opportunity set like and what's the I know what the performance is like, but how's the opportunity? >> Let's not worry about the historical. How's it look going forward? >> The past is the past. >> Yeah. Well, you know what's interesting though about the past is the last four years, people don't realize this, but small caps have gone nowhere. I mean, four years is a long time. I mean, that's college, right? Um, have made no money. You know, maybe up one, it's like 0 to 1% depending on the benchmark. Uh, meantime, the S&P 500 is up since that time, you know, 50%. The QQQs are up around 50 or 60. Uh so significant underperformance in small caps. uh we've been able to to hang in there and generate a you know small annualized uh return you know um I think since inception we're up like seven which is around the same as the small cap benchmarks but as you know we really haven't been invested uh too aggressively been very defensive especially with the cash on average um we're only been about 20 25% invested since inception so you know macro perspective I guess or from the top down on performance you know, it has been great, but we've kept up, but definitely lag the larger cap, which I mean, I don't know how you can keep up these days. I mean, the the uh Nvidia, you know, I heard is like 8% the S&P 500 right now. Um, if you have a 5% weight in that stock, you're actually conservative, >> right? >> Might have a little too much tracking error to keep your job with a 5% weight. So, uh, things are a little nutty again. Uh, it's not too dissimilar than the 1999. I I used to think it wasn't like 99. Um small caps were much more inexpensive in 99, but lately I think year to date especially with the flows going more towards large cap or all towards large cap flows in small cap ETFs are actually negative now year to date. So we're getting outflows and you're getting this kind of this consistent drip of small caps. Occasionally I'll have a really good day like today uh where they try to flip the narrative but without the flows you know it's gonna be really hard for u for small caps to rebound. Why why do you think small caps have struggled so much over the last four years? >> Well a lot of it's the flows and a lot of it's the cycle and the mega caps of course have been where the earnings growth have been. The earnings growth for a lot of small caps have been flat. You know since 21 we had the boom in profits and stock prices. 22 stocks rolled over and since then it's been hard to grow earnings for a lot of these companies. Uh you have a lot of uh goods companies that boommed during the COVID period because of all the stimulus money, the checks being handed out and now several you know a lot of the consumer names are now in in recession. Uh transportation's in recession, energyy's rolling over. Um there's a lot of industries now that are in recession. That's one of our themes is to buy businesses already in recession. You're not we're not waiting. We really love to buy cyclicals that are experiencing um declining earnings uh declining revenues and are in recession. So uh but but to answer your question, I think it often flows uh earnings growth and um buybacks too. I I think buybacks is a significantly underrated understated uh catalyst of asset inflation especially I mean obviously in the equity uh markets where that's been more towards the large caps where you have profit growth you usually have you know the the the ability to or more likely to uh do buybacks. Buybacks now are you know four to five times greater than uh passive flows. You know everyone talks about the passive flows but the buybacks are are much larger. um on a flow perspective. Um so I think that's helped the large caps as well. >> You think the large caps are Yes. So the large caps are doing lots of buybacks but at very elevated valuations and they've got the the cash flow to support >> isn't like Apple's get like planned to be like a hundred billion of the one trillion that are you know kind of scheduled or something like it's a insane number. >> Yeah. The buyback for Apple I think's 100 billion. You know their market cap now I think it's trying to get you be the next one to four trillion. I think it's three something. Um, so on a percentage basis, you know, the buyback, you're like, well, it's not all that, you know, relative to the float, but it's a lot of their, if not all of their cash flow. So, so Apple's balance sheet is, you know, and I'm not an expert on Apple, but just just by glancing at it, is really not that strong. It has, last time I looked, I thought it had negative working capital. Um, you know, I know they have some some securities on the on the balance sheet, but that's offset by the debt now. It's not the balance sheet everyone used to talk. Remember everyone used to talk about Apple's balance sheet. It it it's a lot worse than a lot of the companies we follow, you know, small caps. I mean, we do it on percentage basis. Um, so I don't really get the Apple Apple balance sheet. And of course, now they've committed to investing, what was it, $600 billion of capital in in AI or chips or investing in the US. And I I don't know where that's going to come from if they're going to borrow to do that. So, uh, yeah, Apple's really interesting, but but again, I'm not an expert. >> You can just say those sort of numbers though, can't you? You just say, "I'm going to invest 500 billion." And they're just like, "Okay, that means >> Yeah, we we were talking earlier about AI and you know, if it maybe the number is 500 billion a year in investment." Um, I mean, that is just a crazy number. It's just we just throw around these big numbers now because they've gotten so big. Um but I mean I remember back in the tech bubble we weren't anywhere close to that kind of investment in the in internet and in telecom. Uh so this is a lot of money you know we go through the conference calls like we do last quarter I don't think any company we we really follow uh said anything positive about AI are using it you know for to enhance productivity yet or and create revenues of course it's very early um that's a big capex number you know you have to hope at some point you get a return on that capital but it's a huge uncertainty but it is one of the areas that is driving investment in capex you know that's one thing I would day where we have a lot of industries now in small caps in recession. The ones that are doing well, a lot of them are doing well because of kind of that forced investment or the aggressive investment either in infrastructure because of government spending or AI infrastructure. >> It feels like 1.0 in the sense that there's an enormous amount of excitement and investment in AI but no very clear path to generating much income or revenue out of And I wonder if you know I I I understand that the AIS are getting close to their limits of like how much we can improve them. And so the next part of the story is going to be making it useful and building it out which is sort of like what happened to the com post 2000 2000 to 2025 was building out all the >> I mean you know AI right now you know what you could do with it. It's obviously a very good search engine but it also writes very good raps. I mean, if you like rap music, so if you're a rap content provider, I think you're toast. You know, you just you might as well find a new gig. Another thing it does and not too well was I asked AI what particular bat to buy for my son. He's in 14U baseball and it told me to buy a drop. >> I can help you with that one. >> Yeah. Well, well, Jake, it said a drop five, but the rules for this league and I game specifically >> 14U, you need BB core. >> You need BB core. Drop three. So, I go out and buy the Drop Five. Well, AI cost me $300. So, there you go. So far, AI is not helping me. >> It does make a lot of mistakes. I think we've >> Well, it's interesting with AI, you know, you you'll use it and you're like, "Wow, it's very it knows a lot." You know, it's very interesting, but then you ask it about something you know a lot about, you're like, "Wait a minute." Now, >> the the other thing it does, like, you know, it's trying to find the most likely word that follows the the word that came before. And so it gives you the most mid >> take on everything. It gives you the absolute mainstream take. Like if you want to say something interesting, which is like definitionally not the mainstream take. It's going to be a fringe take. It's terrible. I think of generating those fringe ideas. >> I agree. And the content is just like you said, it's mainstream. It's not very creative. >> Um I actually recently tried to ask it to write a blog for me using our content on our website. I was just curious and it, you know, it just was, it was almost like a highlight reel of what we had written. It just wasn't very good. >> But, uh, but I mean, you do spend 500 billion. I hope it improves and I'm sure it will. Um, so so it'll be interesting to see how that that plays out. But just like the tech bubble 99, a lot of those companies uh same path of the stock price eventually collapsed. Some many went out of business. Um, the ones that were initially benefiting. So, so we we'll see where this all goes. I'm I'm sure something will come out of it, but how it affects asset prices and and the economy too. Uh cuz right now you've got you've got AI boom, you have government spending boom, you know, two trillion deficits, 6 trillion in spending. Uh you got credit spreads are tight, asset prices, stocks are at record highs, home prices are at record highs. They never came down. Um I think it's really tough in this environment to be in a recession. So, we've been very critical of valuations, but we haven't really said, you know, we're in a recession because there's just so much spending, so much stimulus, uh, to drive earnings and drive the economy. And even though they're artificial, that they are having an impact. So, you know, we're careful to extrapolate this environment. So, I think we're more about we're normalizing instead of extrapolating, which is keeping us out of a lot of these names. if if you use sort of more normalized profit margins. >> That's one thing I did notice when I went through the uh Dennis site. They track the profit margins for large, mid, and small. And I published this on Twitter. And the large is at like I forget now, but it's like 13 plus, could be 15, something crazy like that against the long run average of six. And mid >> mid is well down but it's still higher than it was preco and so small which I found really shocking. The margins there are still higher than they were preco even though they're they're well below mid which is well below large but they're still elevated. So I don't know what all that means. I don't >> I would have thought that I would have thought Russell 2000 margins look like crap with just based on the narrative. Yeah, we're finding a lot of um have and have nots. You know, there's some some businesses that are generating incredible margins. You know, those are the ones that have benefited from acid inflation and inflation in general where they've been able to pass on pricing. You know, you look at something like a Costco, um if you have 30% inflation over 5 years and you can pass all that on, which they have, their margins have been maintained. I mean, they they love that. They love inflation. um you know maintaining your gross profits and gross margins are two different things. You know they maintain their their gross margins. So inflation can be wonderful for certain businesses but it can be detrimental to others that are more price takers and don't have that ability to pass on prices. So I think you're seeing a lot of dispersion um from a bottom up on on margins and there's certainly things that are skewing that number one way or the other. Eric, wouldn't you say though that that's kind of like a a short-term phenomena where >> your fixed costs were paid for with, you know, higher more appreciative dollars, but then when it comes time to start putting a new roof on a Costco or >> Amen. >> build the next one, it's going to be more expensive to do that and eventually that's going to show up in your margin, right? >> That's a very that's a great point. I don't think that gets discussed enough, but frankly, when do fundamentals like this get discussed? I mean this is you know saying that your capex is the you know below average because of inflation. I mean that's a great point. So so right so margins using you know historical depreciation are likely overstated. Uh great example are a new truck now for for the trucking companies probably 20 30% higher especially with the the new standards on on on fuel efficiency. So uh there's a lot of that. So there's a lot of deferral going on because they know and trucking is another good example. They are deferring purchases of new trucks. A lot of a lot of the public companies are that's also because of trucking is in recession. But but nonetheless when they eventually have to go back in and rebuild their fleets, it's going to be a lot more expensive. But that's that's across the board. That's a lot of PP uh property plant equipment. >> Yeah. That's like the next investor's problem two years from now, >> right? >> CEO next CEO >> two three years down the road. That's like three generations of investors. >> Yeah, >> that's >> what do you think the uh the earnings of Smalls uh do you think there were there was consumption pulled forward through co and through all the STEMI that's come afterwards? Cuz I've noticed the same thing that there's a very definite peak around 22 in terms of margins, in terms of earnings, in terms of stock prices and then >> it's run backwards since since then >> to today. I agree. So, so like an example would be Carters, right? They're the uh market leader in children apparel, baby apparel. Um they were crushing it after co, you know, everyone was getting their stimulus checks and they didn't really care if they were paying $10 or $12 for a pair of pajamas. Um so they were able to raise prices and and not only did they have some volume growth, they had the pricing power and all of a sudden they were they were making considerably more margin and and cash flow and profits. they start buying back stock in the 80s, $100 stock, you know, it's just booming. They're making$878 a share in earnings. Um, and then the the the COVID stimulus went away, the inflation hit. Now young families are having to decide between, you know, paying rent and buying new pajamas. >> Yeah. >> And the the decisions a lot more >> student loans they got to pay now where they weren't before. >> Yeah. So now you're like, "All right, I'm going to pay rent and now no pajamas for Timmy." And um so now their earnings are probably $2 $3 a share. Stocks at 25. Um and a lot of companies did that especially on the consumer side. They extrapolated that boom. Uh transportation did it too. And now some have gone bankrupt. Uh most are in recession. And it's an area of the economy that um I think illustrates what's going on with the consumer. you know, the the the uh difficulty they're having making ends meet and and especially on the discretionary spending, but even food. I mean, even staples now are getting hit by uh the I call it the affordability crisis. Everyone's focused on inflation, but the companies will tell you it's not inflation. It's the inflation we already had. It's the 30% p, you know, lower purchasing power or cut in purchasing power. And it's affordability that's the issue. And they're not addressing affordability. I mean, the inflation rate's at 3.1% now on the core. They reported today, and we're actually talking about cutting interest rates when the biggest problem, if you do a survey, it's the cost of living. And they're going to cut interest rates in this environment. Stock prices are at all-time high. Home prices are at all-time high. Cryptos are 4 trillion market cap. Um, I could go on and on. Credit spreads are so tight, corporate bond markets on fire, and we're cutting rates in this environment. I mean, it is insane, you know, and and I just I don't get it. And it's it's like, what are you doing? You know, the the populist is going to vote everyone out. They're going to give, you know, won't say that. All right, I'm going to back up here. Um, but they're going to vote him out, right? And they're going to they're going to bring someone in that's going to um redistribute the wealth. And you can't blame them. >> I said no rants, Toby. I'm sorry. >> Welcome to rants. Other than that, how was the play, Mrs. Lincoln? >> I love the Fed. The reason we love the Fed is they always screw up. You don't know when, but when they do, it's so bad. And the opportunities are so wonderful. And this is this is going to be one of the best cycles ever for patient investors and disciplined value investors, which we talked about earlier. There's probably about 14 left. Um, it's it's going to be great. So, I you know, I like to I like to rail on the Fed, but at the same time, you got to appreciate what they do in the volatility they eventually create in in the aftermath that will help us and our clients um hopefully make some money. >> I think Pal's done a reasonable job. I think that the problem was that the three lunatics who preceded him who have created the you know I think um Bernani certainly was probably the worst of the lot but then Yellen's just continued everything that Bernani did and Pal's been the first one to raise rates even though he's probably done it too slowly but if I understand that people use the 2-year as a reasonable proxy for where the the Fed funds rate should sit and pal I think has tracked it more closely than anybody else even though he's a little bit below through the entirety of the the 2020 recovery. What do you think? >> Well, I think you know in 2018 I thought the same thing and he started to raise rates and it looked like he was going to try to normalize the balance sheet and then stocks fell 20% and he >> he flipped so fast. >> Yeah. >> Um stopped raising rates started to QE again. and they called it something else. And um and then during co every company we were following practically was clearly clearly forecasting higher prices. Their costs were going up. We wrote about it a year before and it just was so obvious and I just we couldn't believe the Fed was was still at zero and they were still printing money. I mean it was crazy. >> What are all these years doing there? >> Yeah. 9% inflation and then you know everyone says what's going to bring down this this market cycle. I said well I thought 9% would have done it you know of an inflation but it but it didn't. Um so I I think he started out with good intentions and I think all the central bankers probably have good intentions you know but no one wants and it's not his fault that he's in this situation you I agree. I think Bernanki was the godfather. I mean, Greenspan was he was horrible, too. But but at least he never printed money, right? Bernanki printed money thinking that was actually a solution to our problems. Uh which every central banker that studied history should know that is the last >> he studied history. He was an expert in the Great Depression. >> Yeah. When people talk about housing now and I'm like I would because we sold our house in the bubble and I would sell it again if I wasn't if there wasn't money printing, you know, but it's so it's such a big risk. uh to to sell and rent right now because of the fear or the real possibility of them resorting to QE. Um which they might probably going to have to do at some point. Um so anyways, I was a fan of Pal also first. I think he tried to do the right thing and then when he saw, you know, like whoa, you know, I can see how this could all unravel pretty quickly with me, you know, trying to do the right thing. He backed off and now he's just trying to make it to the finish line and I think he's gonna make it. Uh but just like Greenspan, Greenspan made it to the finish line and still got blamed for the housing bubble. I think I think Pal who printed more money than any US central banker in history will also get the blame when the >> on partial off a higher base. >> Yes. Yes. And but I agree with you on Bernanki and Yellen just kind of she didn't want to do a whole lot of anything. She's just like, "Whoa, I'm just going to not do anything and see if I can get through this." And she did. You know, credit to her. So, uh, yeah, it's it's been a it's been a fascinating central bank kick the can. Uh, you know, it's just like a it's just like an average banker. When you have bad loans, how do you how do you not let bad loans go bad? You write more bad loans. So, so it, you know, it it creates a perception that as a percentage that the loans aren't so bad. Uh so so uh they're just going to keep it going until something snaps. Do >> you know the thing that amazes me is we're still we've still got a 103 inversion. You know that started in it's started in 22. We got very inverted. We've been inverted for a very long time and then it's been basically at zero or slightly inverted for the last like 18 months or something like that. So we're now like three or four years into this inversion. >> Is that a record? It's a record in the data that we h that that they have on the Fed website, but I've heard from uh I just I'm forgetting the forgetting the the firm name, but I Adam Butler and co said that um >> yeah, just has longer has a longer history that shows that there have been very long inversions in the past >> in the last likeund since since 1900 basically. Yeah, the long end's interesting. You know, I think the 10 year now is a little over four and the the 20-year, you know, is like 485. So, you could still get a decent absolute return yield if you'll take the uh maturity risk. You know, it seems 5% for the Fed is a scary number. You know, they every time we get close to exceeding that on the long end, you know, it's like it seems someone seems to be on top of that making sure we don't break out there. So, uh, that's a hard number or interest rate for us to afford and I think the government's very aware of that. >> It's been up every single year since 2020. I' I've plotted out that the curve since 2020 and it's been up the long end has been up consistently every year by a point or so, including like 24 to 25. The front end has moved all over the place, but >> it's the long end hasn't looked back at any point. I don't know what they do about that. if they need to do anything about it. >> I mean, what was the 10 year when the Fed cut last year? It was three something, you know. I think it's up. I mean, I'm not positive. 50 75 beeps. I mean, I don't follow the tenure too closely, but I know it's up quite a bit. Um, so I think that may have caught them off guard where like, whoa, we lost control of the the long end here. >> Well, certainly mortgage rates haven't taken followed their the the pi piper tune. And what happens if mortgage rates do fall? Uh what if they do cut rates, let's say, to zero, and mortgage rates go back to 3 to 4%. I mean, you should see a million-doll home around here. It's like, so what, you know, and then and now you're going to drop rates, you know, and and and spur the housing market again. You know, that goes back to affordability. And I don't think you're doing anyone any favors uh except people with paper assets. But I don't think it helps much either because there's a lot of selling pressure that's going to come through from the boomers downsizing or you know shuffling off this mortal coil over the next 20 years. >> There has to be Well, there has to be buyers on the other side. It's not going to be Black Rockck. >> There has to be some young family somewhere, >> right? >> Thank God for Black Rockck keeping those young families out. >> Yeah. Well, going back to Carter's, you know, one of the headwinds they've had is the birth rate. Um the younger generations can't afford to have kids. I mean, it's kind of sad when you think about it. If you want to talk about the consequences of easy money, I think one of them is clearly there's less babies. Um, so that's not cool, you know. So, uh, yeah, that's that's going to hurt a lot of things going forward. Population growth is is going to decline. Um, well, plenty of money and plenty of paper money, but fewer fewer people to make goods and services. >> Well, surely surely if you can print wealth, you can print babies. I mean, this is >> You would think. Well, AI might fix that somehow. We'll see. They might not be humans, but >> what's um what's interesting in small cap land in terms of uh industries? What do you think about energy? >> Uh we bought our first energy stock last quarter, uh Cord Energy. It's an EMP out out in the uh out in the Bakan. And um so, you know, we valued it about $139. We're trying to value the uh the cost of the reserves in the ground, which we believe is about $15 a barrel, has over 5% dividend. You know, that one of the things I like about energy is how they've been so disciplined with cash flow. And um I thought at first cuz most of the time I've been in the industry, you know, since the early 90s drill, they all just drill drill drilled, you know, regardless they got paid on production growth. But over the past 10 years, they've done a really good job. Uh but when when oil prices got down, you know, in the 50s, a lot of the EMPS started to sell near replacement cost of the reserves. Uh so that was that got very interesting. We're able to pick one up there. U so we like energy u not all of them, but we like certain ones, especially the ones with better balance sheets. Some of them because they have been paying out dividends and buying back stock don't have the best balance sheets. So we're we're we're really careful there. Uh we like transportation. We like the trucking companies. We own H Heartland Express. Uh that's old school value stock that's gotten absolutely destroyed. Um so we like companies that are already in recession and and that's a great example um with with the trucking companies. This is the third year that they've been in recession. Uh the business and the industry and uh we're avoiding companies that are doing really well. You know the opposite. >> Me too. That's their stocks too. So it's uh it's been a it's it's been a lot you we talked about this earlier. It's been a lot like 99 where we're buying really out of favor names that the stocks are in decline, the flows are horrible. Um the earnings are declining, but you know, that's actually when you want to buy cyclicals when things are bad and getting worse. Um because the stocks when you get them cheap, you never you're not going to get an energy company cheap when oil's at $100 a barrel. Uh you get it cheap when it's at 50. So, uh painful operating results right now for a lot of these companies, but some are stabilizing. We also like companies right now that are intentionally shrinking. Hartland qualifies for that too. They're actually shrinking their fleet. They're getting very little in capex. Their depreciation is 160 million a year and their net capex this year is going to be 40 million. So you're getting 120 million free cash flow by breaking even, right? And this is on a 600 million market cap. >> So they're they're generating plenty of cash flow. They actually bought back a million shares last quarter. U we own Monroe. They do uh auto repair shops. That's another one that's shrinking. They closed 145 stores. They have they have over 6% dividend. They've generated a ton of cash even in this period. But but the consumer is cutting back um on maintenance on cars. So, uh you know, just be careful out there. You see a car, you see an older car, it might not have brakes, you know, so might have bald tires. So, beware. Uh but people are deferring those. We can only defer those for so long. And uh but yeah, business has been poor for them, but again, that's a consumer discretionary that's not really discretionary, but that's that's when you want to own those, too. Uh but their comps have turned positive recently. So So we're we're hopeful there. So companies in recession, companies in recession that are stabilizing, even better. Companies in recession, stabilizing, they have good balance sheets, even better. So that that's kind of what we're focused on right now. >> Energy versus the market is as cheap as it's been. only two times cheaper were 2020 and 2000 to >> in this environment. Wouldn't you kind of want to own something that's tangible at a discount to replacement cost? I mean, I I find that attractive. We we own a farmland re too farmland partners. M so uh if I can buy acreage of farmland at a discount or uh reserves in the ground at a discount or even a um you know some receivables we own uh Kelly services the temp agency the receivables are at a discount to market cap u yeah that's great we love asset heavy companies right now too that that are selling a discount to to tangible book >> let me give a quick shout out and then JT you want to do some veggies >> yes sir >> senator Domingo, what's up? Danny Valareerezo, what's up? Mac Tallahassee, Dead Cat Gully, Andra Pradesh. Uh, Jupiter, Florida, Cincinnati, Boisey, Budgy Smuggler, Les Les Wan, and Budgy Smuggler Australia. Fairfax, Randall, Gerard's Cross, Main Streets of Gerard's Cross, emphasis on Main Streets, Brandon, Serbaton, Madira Island, Portugal, Toronto, and John Battle gave us a $50 tip. Thanks, brother. Appreciate you sponsoring the veggies. >> That's >> today's veggie sponsor is John Battle. That's a brand new thing we're doing just today. >> Yeah, we just thought of it. Better give him a rebate. [Laughter] Corvalis Oregon last one and then we we'll come back to the question. JT four is yours. >> Yeah, you guys did an amazing job uh team things up with the first part of our discussion as you will as you will see totally unbeknounced. Uh so imagine you're standing on the deck of a wooden ship in the Arctic and the air is stinging your face. It's so cold. It's the spring of 1674 and you've been sailing for weeks through this shifting ice. Your supplies are running low. You probably have scurvy. The men aboard are restless. And Ernest Shackleton won't be born for another 200 years. Then someone shouts, "Land hoe." And you squint toward the horizon. And there it is, an island fortress rising high above the sea, complete with jagged cliffs and snowy mountain caps. It looks so close you could almost throw a rope to it. And the crew cheers, of course. At last, we found salvation. You steer towards it for hours and yet as you're getting closer, something strange is happening. The island doesn't grow larger. If anything, it seems to be drifting further away. And eventually, you realize the terrible truth. There is no salvation. What is going on here? Is this just a sailor story like mermaids or the kraken or a superstition like you should always step onto a boat with your right foot? Uh, no. The reality is the sailors did see land, but it was actually a mirage. And in fact, you guys might not know this, but there are two types of miragages, superior and inferior. And you've no doubt seen the desert image, which is uh you know, the desert mirage, which is that shimmering pool of water on a hot road. That's the inferior mirage. The superior mirage is different. And and here's how the physics of this works. Light doesn't always travel in a straight line. In in uniform air, yes, but the atmosphere is rarely uniform. Cold air is denser than warm air and density changes how much the light will bend and a property that's called refraction and this is why things look closer underwater when you're viewing them from above the surface. So under normal conditions warm air sits near the surface and cool air above it. You know think about the temperature up at the mountain top compared to down in the valley below. In these normal conditions, the cold layer is above the warm uh and that light then bends only slightly and the world appears where it really is. A temperature inversion which is not to be confused with Toby's rates inversion uh flips that layering. Uh the cold dense air is then near the surface and the and then on top of that is the warmer lighter air. And when that light from a distant object enters this inversion, it curves downward towards the denser air before it reaches your eyes. So your brain, which is assuming that light moves in straight lines, interprets this as the object being higher than it really is. So this temperature inversion is common near the Earth's icy poles, right? Because it's very cold air uh off of the snow. Um and the result is these superior images is that objects are hidden by the curve of the Earth. They seem to float above the horizon. You're actually can see things like over on the other side of the horizon. So mountains that are hundreds of miles away uh you know appear to be rising into the sky in front of you and phantom ships may be sailing you know beyond where you could see like there they are and even coastlines you know seem to be hovering in midair and and the images actually aren't fuzzy sometimes they're often sharper than real life because the air acts like a lens uh and like zooms in a little bit and this is most dangerous part uh is that it's incredibly believable that this is actually there and historians speculate that the Vikings ventured to North America sometime around 1000 AD after spotting a superior mirage of the mountains of Baffan Island from the coast of Greenland. So they're almost like peeking onto the other side of the earth uh because of this uh and it looked to them like the land was much closer than it actually was. So then like okay let's set off and go explore that. So of course you know the the cousin in in the desert of the Mirage is is the in the inferior one and it works in reverse. And here, heat near the surface bends light upward, which makes the sky actually reflect off of the ground, and that creates the illusion of water on a scorching road or or pools shimmering in a, you know, a a false Sahara oasis. So, let's see if we can torture this analogy into something useful. In the Superior Mirage, your eyes aren't really lying. They really are receiving light from something that's real. The problem is your brain's interpretation of it. And that bending of light through layers of air makes the horizon look much closer than it truly is. And the closer you think it is, the more confident you feel steering toward it. So I can't help but think that that might be where AI is today. So uh the cold air is the hard, you know, measurable progress. These frontier LLMs are scoring higher than 90% of humans on specific tests. Automated uh coding assistance helping, you know, save weeks of development time. these AI agents that are boosting productivity in narrow domain domains. Um, and those are real tangible wins. Like that's the island on the horizon. The warm air might be the capital markets and the media layer kind of above that. You know, the trillion dollar TAM slides, the breathless coverage about AI replacing entire industries next quarter. Uh, stock market pricing in decades of compounding before any cash flows arrive. Half the workforce is being laid off by Christmas. uh you know that speculative heat refracts our expectations bending the arc of reality so that 20-year payoff looks like it's two years uh you know away isn't an inevitable thing. So uh you know these these mirages are then precise enough to tempt people into misallocating their resources. So they set sail they burn precious time and fuel and and when the illusion fades the true distance finally is it real reels itself as being greater than than ever before. So, who knows like maybe the real breakthroughs might be uh you know a decade away but the Mirage convinces us to act and spend as if the miracle is right around the next bend. Um and so just like those those Arctic sailors like we might get there eventually but and the land is real but the timetable probably isn't. So that's why, you know, I when I've recently was reading a headline that Meta is tapping Pimco and Blue Owl for I think it was $29 billion of debt for data center projects. Like that that's a little concerning. Like you tapped your balance sheet, you took a bunch of cash out, now you're going to, you know, lever it up to keep going. Well, that that implies then that there's a time period that you need to reach shore by. And that that can be difficult. Uh, so I don't know, Eric, is there are there any signs that you see today that kind of rhyme with the.com period when it comes to this, you know, the future being out there beyond the horizon, but it looks closer than it really really is. >> Yeah, of course. I mean, u it's feeling more and more like 99, you know. I remember 99 still very well. I was a young manager. Um, and and it just felt the same where you just felt like an idiot, you know, and you're missing out. It was very hard. Uh we were talking earlier about that's when I went and enrolled to graduate school because I I thought, you know, I I didn't know what I was doing and my career was over. Um but of course it all and this was what I don't think people really appreciate. Uh the the internet bubble popped without warning. Uh you know, I think everyone thinks that there's going to be a bell that rings. They'll have time to reallocate capital. And even though they probably know right now they're they're checking, you know, chasing a speculative bubble, they think they they won't get hurt because they'll be, you know, smart enough to get out. But I remember one day just coming into work. It was March of 2000 and it just crashed. I mean, these internet stocks crashed. So I think there's a lot of similarities right now, but uh investor complacency is probably the biggest and and the feeling again of of when you're not participating. uh you know I was a lot younger then so I I I thought I was a lot smarter then you know so it was I think it was harder for me than the 99 bubble um because I went from feeling so smart to so stupid that was that sort of transition was really hard for me personally but this time around I mean it still is horrible I mean I I hate I hate not participating it's you know we we want to be fully invested you know we really do we want to be making money we we would love to be making 20% a year on the QQQs and compounding that. I mean, just for one second, try to imagine being invested in the Mag 7 over the past few years. You go to bed, you're so happy about making how much money you made, and then you start thinking, well, how much are you going to make tomorrow? I don't know. I can't wait. You know, it's going to be so awesome. So, >> and they're great businesses, too. >> Yeah. They're such great businesses. It's so easy to be invested in. >> Yeah. And take that feeling, Toby, and then the inverse of that is what we're experiencing. >> And they're terrible businesses. The businesses that we're invested in deserve everything they get. >> But here's the bright side is when it ends, and it will u the feeling of being an idiot, uh, and then transitioning to to feeling the that vindication feeling. And you know, you know, we don't really care about relative performance, but when you outperform by thousands of basis points is pretty cool, you know. So, the the other side of this is uh is amazing, but making it all in one piece and maybe with a business, maybe not, you know, maybe with some clients, maybe not. >> Um it can be wonderful, but I I think at this point in the cycle, um there's there's fewer and fewer professional managers willing to do it. And one thing I would note about 99 too, this is very important. A lot of value managers portfolios did their own transition to try to participate somehow some way and they they did it by buying those stocks that maybe were they tried to classify its value. They tried to still hold a value category but still cheat kind of on the side. not cheat's probably a wrong word, but give in a little bit on principle to participate and you can understand that, you know, to try to to keep your job and and keep assets. Um, so you can still be value but not really be value. So you be really careful right now if you're a capital allocator, look under the hood and if you see a value fund doing really well right now, uh, especially on the small cap side, it might be a red flag. uh might might not be it might be an incredible stock selection, but a lot of the the uh genuine small cap values we believe uh have horrible charts right now. You should see when we when we're looking for new stocks and we see a horrible five-year chart, we're like, "All right, that looks awesome." You know, that's what we're looking for. Look at this. >> Yeah. Oh, give me an ugly fiveyear right now. Um but a good a really strong performing fund right now will have some really pretty fiveyear charts. So, I think you want to be careful of those. Do some do some research, deep digging there, and make sure that there wasn't a shift in philosophy or process and strategy. Eric, if you were an allocator right now, how would you how would you try to untangle luck versus skill, especially if you had a 10-year track record to look at, let's say, which sounds wrong, but >> yeah, but you know, even a 15-year uh Jake, now uh 10 and 15, 5, 10, 15 all tell you to allocate to the S&P 500. Um, and how are models made? How are capital allocations modeled made by looking backwards? So, everyone's like, you know, oh, small caps are going to come back. are so much cheaper. You know, I don't know if I would agree with that because if you look backwards, uh, all the numbers tell you to buy large cash and that's how these capital allocations are made. The pretty pie charts that you get when you go to an advisor and they tell you how they're going to chop up your portfolio and where it's going to be, the the numbers will tell you to be in large caps. And until that changes, and that this is another thing that was similar to the late 90s uh 2000, until the large caps get just destroyed and those backward-looking numbers don't look so pretty, the small caps are going to lag. But once that happens in 2000 to 2002, small cap value stocks had very very good gains. U but the uh large caps, you know, in the NASDAQ was down what, like 80%, something crazy. Uh so you were able to make money in a severe bare market by by doing exactly that kind of buying what's out of favor before the bubble before the bubble pops. So so you want to be very careful right now because I think most allocations would suggest to to to go with what's done well and it hasn't done just as well for a few years. So they can justify it easily by saying it's been 10 15 years. Uh that's a hard number to dispute versus a 2 year 3 year four year number. Because the cycle's been so long, you really want to be careful because we haven't had a real recession, a real bare market over that period. You want to be really careful now using long, this sounds weird, but you want to be careful not to use long periods of time to make investment decisions. And Eric, when you have a when the world is such where you know buying every dip has worked um the belief in the superpowers of central bankers and governments to do whatever it takes to you know uh keep keep corrections from happening. What does it take like an 80% down to disabuse people of the this kind of Pavlovian dip buying that they've been, you know, so wired to do over the last 15 years? >> I think so. And and there was an article in the Wall Street Journal, I think it was yesterday, talking about younger investors and how they've been able to u buy the dip and have been rewarded. And um it really was a this time is different article. Another one. I haven't had enough of those. Um, so I I do think, you know, as I learned in in the '9s, you know, that wasn't that smart or wasn't as smart as I thought I was. I think that's part of growing up as an investor, especially for the younger generation. But right now, you can't blame them for thinking they're invincible and, you know, they can they can make money so easily. I mean it really if if if we wanted to make money even in our fund right now I think we could do it and I think we could make a lot but I also think we would be setting ourselves up for losing a lot of money you know so uh and you can't I'm telling you you cannot you will not be the person that gets out first I mean if you do you'll be very exceptional timer and we're not market timers but uh you know the risk right now especially on the large cap side and I'm not promoting small caps I don't we don't think small caps are particularly cheap u but they are getting cheaper and there are more things to work on now which is great but as far as the large cap side of the market I mean and back in the '9s too you had Gillette Coke you know 30 50 times earnings those got destroyed and people people they they think because they're in high quality they're protected that's not true you know Costco at 50 times earnings could easily lose half of its value easily um so people need to be be aware of that as well that that quality is not panacea >> a perfect a perfect way to control risk. It's valuation is much more important. >> I got a good stat uh from Twitter. This was a Bank of America global investment strategy. US large cap annualizing $419 billion for 2025, which was the second highest ever to 2024. US small cap annualizing $80 billion in outflows, which is a record. Go small cap. I was amazed that they had that much to lose. >> Yeah. They're all that's just all wiped out. >> Well, what what is the Russell 2000 ETF? It's like 10 billion maybe. I really don't know. But but the but the uh >> I had a look at IWM. IN. >> Yeah. One of the NRM. There's two of them. There's a value in >> it's 4.4 billion. >> Oh, it's embarrassing. and the and the uh the Vanguard or you know whatever it is and >> Vio >> what is that I mean it's several hundred billion I think >> and you know in in the big active funds now you look at let's let's and I don't want to get sued here so I gota be careful let's the contra fund there's a there's a fund out there called the contra fund I won't >> who knows what what what does contra imply to you maybe contrarian >> you know on Twitter a contra is someone who you trade against But >> it does it does sound contrarian. That's right. >> Back in the day it meant contrarian. I don't know what it means now because if you open the hood of that portfolio, it it's like the mag seven fund, you know. Um so so even the active managers I think have figured out, you know, if I don't own the big weights of these names, you know, we're going to risk uh underperforming and risk losing assets. And the fund has done incredible but and so is the assets under management. So, uh, I think if you overweight some of these names doing really well, like we said before, you can there's a way to make money right now. It's pretty easy and that's to play along. And if you want to leverage that up, which, you know, we have the leverage ETFs now, we have options. A lot of people are doing that. So, it's not just buying the S&P or the QQQs. They're uh they're going even further than that. So, uh, it's and those flows are huge, Toby. I mean, I remember back in the in the '9s when we had your 2000, there was like 50 billion inflows and everyone thought that was nuts, you know. Yeah, now you know now we're talking hundreds of billions um going into these ETFs and passive funds. So >> there are a lot of companies that have stumbled over the last even in even in large cap land. I think it's kind of interesting that that it is so concentrated into a handful of names that are performing. I don't know if it's 10, but it's it's certainly in the top 100 and then the 490 or the 400, however you want to break it up, they they really haven't done very much. They've been basically also flat since two 2022. >> It's really only a handful of names that have been a beneficiary of that capex AI spending. >> Yes, exactly. >> That have done well >> through this period. And a lot of that is like >> as we were talking about it's hard to they're deploying so much money like the returns that they have to get out of that money that they're deploying are becoming like they're equally astronomical on the other side to justify it otherwise. and the the I I sort of equate it to like a 99 uh fiber optic cable buildout. And that's not that's not an original thought, but it's but it's a common kind of analogy to make. The difference is that the fiber optic cable goes in the ground for 25 years. Whereas the useful life on these chips like 3 or 4 years before you get another like are we going to be spending at this sort of rate all the time? Like is that just what we're doing now? >> And yeah, how's that sustainable? You know, I always joke about the tech bubble. You know, at least we got the internet infrastructure for that. That was cool. And then the housing bubble though, I go, what do we really get out of that? And then I was like, granite countertops. Everyone got new granite countertops. >> Yeah, it does feel like there's a obsolescence like, you know, I mean, let's rewind even further back like railroads, the you know, huge capex boom. I think it was something like 6% of GDP was being spent on capex during the railroad boom. Well, you know, some of those rails obviously they've been replaced, but the rideaways are the same as they were 150 years ago, right? Like that's right. >> That's really you you advertised that cost. Well, >> but yeah, chips at, you know, let's be generous and say five to seven years even, which I think is what they're they're doing. >> Yeah, but but the ones they're putting in now will probably be obsolete in 18 months, right? >> Yeah, maybe. >> It's great for Nvidia for >> Yeah. I don't know if the customers can keep up with them. >> Well, and in fairness, my understanding is that those those chips they then sell on to like the inference side where you don't need quite as much horsepower apparently. So, it's not like a total like you write zero. >> Well, yeah. I don't know. So, they're not like zeros, but like yeah, the the training chips have to be quite the most powerful apparently. So, those are the ones you got to replace every three years. Are we getting >> this is why we uh we we we do avoid a lot of technology stocks and not because they can't do extremely well, but because they're just hard to value. I mean, we're talking about this right now and none of us can really quantify what cash flows are going to be in year five, you know, let alone year one or two, right? So, it's just so hard to value and u you're not buying a perpetual bond. You don't really know what you're buying. um it's just a tremendous amount of investment with with uncertain returns and that's more of speculation and it could work great. But for us, you know, if you're just kind of discounting a long-term bond sort of investor, those are really hard to uh plug in a model. >> Yeah, you want some steadiness. It seems like energy is not going away anytime soon. I think energy is a reasonable bit. I also saw healthcare is doing underperforming the S&P 500 by the most since 2000. >> We just bought our first uh healthcare device company um maybe I mean in a decade maybe since we since our inception I know but yeah you're right those have been under pressure uh so that's interesting you bring that up we've noticed that as well. Um, one thing I want to talk about which we haven't is is tariffs. You know, we had the CPI number today come in and I I think the the main number was lower than expected and the core number was a little higher. But a theme I wanted to talk about in the quarter was a lot of the companies we follow are uh haven't um reported a lot of impact from tariffs at this point, but it's coming. You know, I mean, it's definitely going to I just want to be aware of this. Well, we should set a little context too, uh, Eric, that, you know, you do a ton of bottom up reviewing of >> I think hundreds, right, of earnings calls that then like give you kind of a bottomup economist viewpoint of the economy. >> Yes. Sorry. >> Exa Exactly. Thank you. So, so we we'll get a feel for what's going on with the companies. And I remember in in, you know, kind of 2021, uh, we were seeing inflation coming, I mean, straight on. And uh it was very obvious to us uh and this is another one of those moments where we see it again. There's going to be a lag, but it it's coming. Uh you know, there's there's three things companies are doing. One, they're raising prices. Uh two, they're trying to pass it on to vendors in the supply chain somehow. And the third thing is they're cutting cost. But almost all the companies we follow intend to mitigate 100% of the tariffs. So they're not going to absorb it. um they're going to use prices and someone else is going to absorb it a and they're going to do productivity cost cutting. So this will have an impact I think late this year definitely by 2026 inflation numbers will go up especially on I mean it will go up on goods and goods for sure we we believe uh so so just keep a look even though we haven't really seen it yet it it's in the pipeline u companies when this all started happening in April they kind of all froze none of them really knew exactly what to expect or the real numbers to use so they couldn't do anything but now they have more clarity they're taking action u and this could affect jobs as well uh later this year, early next year as again they're going to cut they're going to cut costs or try to improve productivity. Another thing I like too is a lot of them are going to uh re-engineer their products. So they used to call it lightweing, you know, get less, you know, and then the whole strengthflation theme came out and people made fun of it on the internet and so now they no longer call it lightweing. They call it re-engineering, which sounds a lot better, you know. Hey, I'm not getting ripped off. the the re-engineering that's gonna make it better. But uh >> we re-engineered this bag of chips to have uh eight chips in it instead. >> Exactly. So, you know, we follow an apparel company. They're re-engineering shirts to have less cotton and and they and they they spin it. Oh, it's it's much bre it's more breathable now. >> Yeah. At some point, we're all going to be naked because of all the re-engineering. But so that that's another thing to watch for. uh you'll see changes in packaging and and product offerings and how they were made. So uh so yeah, it's coming. So so there's no free lunch. >> The thing that I don't understand that seems like you know if you just think about like you ask yourself and then what you know one time on this okay we've got like huge margins um known cost pressures coming from tariffs just even having to just write the check to the government for to get something inside the the the the borders of the country. Okay. And they're all saying they're going to be passing this along. But isn't there one company, two companies that would defect and say like, well, you know what? I want market share. I'm not going to I'm going to eat my margin that I had. I'm going to pay this and like I'm going to pass this savings on to the consumer, which at some point that's what technology has meant like it's, you know, we we all have more from doing with less input. um you know at some point like where is the game theory of the competition of between businesses to lower or not raise their prices commensurate with the tariff expense? Well, you know, especially with small caps, a lot of these companies are already under margin pressure uh with with rising costs. You we talked about trucking earlier. It's not just demand, but they have a lot of their costs, the labor especially, and the equipment cost, replace equipment that's going up, insurance is going up. So, you have a double whammy right now with the costs are rising. So, now you throw the tariffs on that too. It's really going to be hard for them to uh to eat it right now. Just the way things are going for and Toby, you talked about this earlier with the S&P 500. you know, the 400 or less, you know, are actually not growing very very well right now. So, it's just a hard time to ask someone to a business to eat it. Um, but in aggregate, you're right. I mean, the profit margins you would think would would somehow come down and but um that's being skewed by the mega caps. Um, one thing real quick on inflation I want to discuss too, um, is a theme we're seeing too with companies and that is a premiumization where they are selling more towards those that have benefited from asset inflation. And I think that's really um something that, you know, we talk about one times with the tariffs. Something that's not one time until stock prices and home prices fall is this trend towards selling to the wealthy. and they are more uh lately been more impactful in setting prices than the lower end. Um so you have two economies. The high end that's willing to pay anything and the lower end where where they're where they're buying less u trading down. There's two things going on. But as the as the wealthy uh get wealthier, they've been they've been more willing to pay any price really for you know you we went to Panera and I bought my daughter a small mac and cheese and a breakfast sandwich. The breakfast sandwich was tiny. It's like the size of an apple. The mac and cheese was this little bowl and it was $15. And I was like, "Are you serious? I How much is mac and cheese?" She said, " $7. I got I go to Publix and get a whole box for $2. >> There goes our Panera sponsorship." >> Yeah. But if But then I was thinking, you know, if I own the QQQ's and Max 7, you know, that $7 Mac and Cheese, whatever. >> Yeah. So they're setting the prices more towards uh the person that that is flushed with asset inflation versus the the small cap value manager. But so I do I do think that's really interesting. Um the price setting right now that's going on. You you saw it with Delta, right? Delta's premium seating last quarter was up 5%. Um nonpremium was down 5%. I think that's the perfect summary of the economy right now and the perfect summary of of what we're seeing with prices. So there'll be some discounting on the low end maybe. Uh but companies have figured out they're better off doing less and making more. Uh it's a theme they learned during co you don't have to be at full capacity to make money. You can you can do less, charge people more, make more. It's a lot easier. >> Hey uh Eric, we're coming up on time. Thanks so much for spending time with us today. But if folks want to follow along with what you're doing or get in contact with you, what's the best way of doing that? Uh palm valley capital.com is our website. So uh if you're interested, stop by and really appreciate you having me. I always enjoy our conversation. Um Toby and Jake. So uh until next time. Thank you. >> Sign up for Eric's blog posts. I read every single one of them. >> Thank you, Jake. We appreciate that. >> Uh JT, we got a great great quarterly letter, too. Jamie writes that. So I always I always like to plug that. That's my favorite quarterly letter out there. >> Q Q2 Q Q3 >> Q Y Yep. Q2. Check it out. >> No words of wisdom. I used all my wisdom already for the day. >> That's interesting. >> We'll see you next week. December time.
Eric Cinnamond on small cap value, inflation, tariffs, deficits, Mag 7, and AI cap ex | S07 E27
Summary
Transcript
I think we're live. This is Value After Hours. I am Tobias Carile, joined as always by my co-host Jake Taylor. Our special guest today is Eric Cinnamon. We've had him on before. He's a small cap value specialist and his firm is Palm Valley Capital Management. How are you, Eric? Welcome. >> Hey, Toby. Great to see you. Jake, >> always good to speak with you. >> Yeah. >> How is Small Cap Value doing? >> Awesome. Incredible. Um, >> objection leading the witness. >> I mean, there's no better place to be than active small cap value. >> And then you you sprinkle on the absolute return tilt. And um, yeah, things couldn't be better. Just it's uh, >> well, there's two things. What's the opportunity set like and what's the I know what the performance is like, but how's the opportunity? >> Let's not worry about the historical. How's it look going forward? >> The past is the past. >> Yeah. Well, you know what's interesting though about the past is the last four years, people don't realize this, but small caps have gone nowhere. I mean, four years is a long time. I mean, that's college, right? Um, have made no money. You know, maybe up one, it's like 0 to 1% depending on the benchmark. Uh, meantime, the S&P 500 is up since that time, you know, 50%. The QQQs are up around 50 or 60. Uh so significant underperformance in small caps. uh we've been able to to hang in there and generate a you know small annualized uh return you know um I think since inception we're up like seven which is around the same as the small cap benchmarks but as you know we really haven't been invested uh too aggressively been very defensive especially with the cash on average um we're only been about 20 25% invested since inception so you know macro perspective I guess or from the top down on performance you know, it has been great, but we've kept up, but definitely lag the larger cap, which I mean, I don't know how you can keep up these days. I mean, the the uh Nvidia, you know, I heard is like 8% the S&P 500 right now. Um, if you have a 5% weight in that stock, you're actually conservative, >> right? >> Might have a little too much tracking error to keep your job with a 5% weight. So, uh, things are a little nutty again. Uh, it's not too dissimilar than the 1999. I I used to think it wasn't like 99. Um small caps were much more inexpensive in 99, but lately I think year to date especially with the flows going more towards large cap or all towards large cap flows in small cap ETFs are actually negative now year to date. So we're getting outflows and you're getting this kind of this consistent drip of small caps. Occasionally I'll have a really good day like today uh where they try to flip the narrative but without the flows you know it's gonna be really hard for u for small caps to rebound. Why why do you think small caps have struggled so much over the last four years? >> Well a lot of it's the flows and a lot of it's the cycle and the mega caps of course have been where the earnings growth have been. The earnings growth for a lot of small caps have been flat. You know since 21 we had the boom in profits and stock prices. 22 stocks rolled over and since then it's been hard to grow earnings for a lot of these companies. Uh you have a lot of uh goods companies that boommed during the COVID period because of all the stimulus money, the checks being handed out and now several you know a lot of the consumer names are now in in recession. Uh transportation's in recession, energyy's rolling over. Um there's a lot of industries now that are in recession. That's one of our themes is to buy businesses already in recession. You're not we're not waiting. We really love to buy cyclicals that are experiencing um declining earnings uh declining revenues and are in recession. So uh but but to answer your question, I think it often flows uh earnings growth and um buybacks too. I I think buybacks is a significantly underrated understated uh catalyst of asset inflation especially I mean obviously in the equity uh markets where that's been more towards the large caps where you have profit growth you usually have you know the the the ability to or more likely to uh do buybacks. Buybacks now are you know four to five times greater than uh passive flows. You know everyone talks about the passive flows but the buybacks are are much larger. um on a flow perspective. Um so I think that's helped the large caps as well. >> You think the large caps are Yes. So the large caps are doing lots of buybacks but at very elevated valuations and they've got the the cash flow to support >> isn't like Apple's get like planned to be like a hundred billion of the one trillion that are you know kind of scheduled or something like it's a insane number. >> Yeah. The buyback for Apple I think's 100 billion. You know their market cap now I think it's trying to get you be the next one to four trillion. I think it's three something. Um, so on a percentage basis, you know, the buyback, you're like, well, it's not all that, you know, relative to the float, but it's a lot of their, if not all of their cash flow. So, so Apple's balance sheet is, you know, and I'm not an expert on Apple, but just just by glancing at it, is really not that strong. It has, last time I looked, I thought it had negative working capital. Um, you know, I know they have some some securities on the on the balance sheet, but that's offset by the debt now. It's not the balance sheet everyone used to talk. Remember everyone used to talk about Apple's balance sheet. It it it's a lot worse than a lot of the companies we follow, you know, small caps. I mean, we do it on percentage basis. Um, so I don't really get the Apple Apple balance sheet. And of course, now they've committed to investing, what was it, $600 billion of capital in in AI or chips or investing in the US. And I I don't know where that's going to come from if they're going to borrow to do that. So, uh, yeah, Apple's really interesting, but but again, I'm not an expert. >> You can just say those sort of numbers though, can't you? You just say, "I'm going to invest 500 billion." And they're just like, "Okay, that means >> Yeah, we we were talking earlier about AI and you know, if it maybe the number is 500 billion a year in investment." Um, I mean, that is just a crazy number. It's just we just throw around these big numbers now because they've gotten so big. Um but I mean I remember back in the tech bubble we weren't anywhere close to that kind of investment in the in internet and in telecom. Uh so this is a lot of money you know we go through the conference calls like we do last quarter I don't think any company we we really follow uh said anything positive about AI are using it you know for to enhance productivity yet or and create revenues of course it's very early um that's a big capex number you know you have to hope at some point you get a return on that capital but it's a huge uncertainty but it is one of the areas that is driving investment in capex you know that's one thing I would day where we have a lot of industries now in small caps in recession. The ones that are doing well, a lot of them are doing well because of kind of that forced investment or the aggressive investment either in infrastructure because of government spending or AI infrastructure. >> It feels like 1.0 in the sense that there's an enormous amount of excitement and investment in AI but no very clear path to generating much income or revenue out of And I wonder if you know I I I understand that the AIS are getting close to their limits of like how much we can improve them. And so the next part of the story is going to be making it useful and building it out which is sort of like what happened to the com post 2000 2000 to 2025 was building out all the >> I mean you know AI right now you know what you could do with it. It's obviously a very good search engine but it also writes very good raps. I mean, if you like rap music, so if you're a rap content provider, I think you're toast. You know, you just you might as well find a new gig. Another thing it does and not too well was I asked AI what particular bat to buy for my son. He's in 14U baseball and it told me to buy a drop. >> I can help you with that one. >> Yeah. Well, well, Jake, it said a drop five, but the rules for this league and I game specifically >> 14U, you need BB core. >> You need BB core. Drop three. So, I go out and buy the Drop Five. Well, AI cost me $300. So, there you go. So far, AI is not helping me. >> It does make a lot of mistakes. I think we've >> Well, it's interesting with AI, you know, you you'll use it and you're like, "Wow, it's very it knows a lot." You know, it's very interesting, but then you ask it about something you know a lot about, you're like, "Wait a minute." Now, >> the the other thing it does, like, you know, it's trying to find the most likely word that follows the the word that came before. And so it gives you the most mid >> take on everything. It gives you the absolute mainstream take. Like if you want to say something interesting, which is like definitionally not the mainstream take. It's going to be a fringe take. It's terrible. I think of generating those fringe ideas. >> I agree. And the content is just like you said, it's mainstream. It's not very creative. >> Um I actually recently tried to ask it to write a blog for me using our content on our website. I was just curious and it, you know, it just was, it was almost like a highlight reel of what we had written. It just wasn't very good. >> But, uh, but I mean, you do spend 500 billion. I hope it improves and I'm sure it will. Um, so so it'll be interesting to see how that that plays out. But just like the tech bubble 99, a lot of those companies uh same path of the stock price eventually collapsed. Some many went out of business. Um, the ones that were initially benefiting. So, so we we'll see where this all goes. I'm I'm sure something will come out of it, but how it affects asset prices and and the economy too. Uh cuz right now you've got you've got AI boom, you have government spending boom, you know, two trillion deficits, 6 trillion in spending. Uh you got credit spreads are tight, asset prices, stocks are at record highs, home prices are at record highs. They never came down. Um I think it's really tough in this environment to be in a recession. So, we've been very critical of valuations, but we haven't really said, you know, we're in a recession because there's just so much spending, so much stimulus, uh, to drive earnings and drive the economy. And even though they're artificial, that they are having an impact. So, you know, we're careful to extrapolate this environment. So, I think we're more about we're normalizing instead of extrapolating, which is keeping us out of a lot of these names. if if you use sort of more normalized profit margins. >> That's one thing I did notice when I went through the uh Dennis site. They track the profit margins for large, mid, and small. And I published this on Twitter. And the large is at like I forget now, but it's like 13 plus, could be 15, something crazy like that against the long run average of six. And mid >> mid is well down but it's still higher than it was preco and so small which I found really shocking. The margins there are still higher than they were preco even though they're they're well below mid which is well below large but they're still elevated. So I don't know what all that means. I don't >> I would have thought that I would have thought Russell 2000 margins look like crap with just based on the narrative. Yeah, we're finding a lot of um have and have nots. You know, there's some some businesses that are generating incredible margins. You know, those are the ones that have benefited from acid inflation and inflation in general where they've been able to pass on pricing. You know, you look at something like a Costco, um if you have 30% inflation over 5 years and you can pass all that on, which they have, their margins have been maintained. I mean, they they love that. They love inflation. um you know maintaining your gross profits and gross margins are two different things. You know they maintain their their gross margins. So inflation can be wonderful for certain businesses but it can be detrimental to others that are more price takers and don't have that ability to pass on prices. So I think you're seeing a lot of dispersion um from a bottom up on on margins and there's certainly things that are skewing that number one way or the other. Eric, wouldn't you say though that that's kind of like a a short-term phenomena where >> your fixed costs were paid for with, you know, higher more appreciative dollars, but then when it comes time to start putting a new roof on a Costco or >> Amen. >> build the next one, it's going to be more expensive to do that and eventually that's going to show up in your margin, right? >> That's a very that's a great point. I don't think that gets discussed enough, but frankly, when do fundamentals like this get discussed? I mean this is you know saying that your capex is the you know below average because of inflation. I mean that's a great point. So so right so margins using you know historical depreciation are likely overstated. Uh great example are a new truck now for for the trucking companies probably 20 30% higher especially with the the new standards on on on fuel efficiency. So uh there's a lot of that. So there's a lot of deferral going on because they know and trucking is another good example. They are deferring purchases of new trucks. A lot of a lot of the public companies are that's also because of trucking is in recession. But but nonetheless when they eventually have to go back in and rebuild their fleets, it's going to be a lot more expensive. But that's that's across the board. That's a lot of PP uh property plant equipment. >> Yeah. That's like the next investor's problem two years from now, >> right? >> CEO next CEO >> two three years down the road. That's like three generations of investors. >> Yeah, >> that's >> what do you think the uh the earnings of Smalls uh do you think there were there was consumption pulled forward through co and through all the STEMI that's come afterwards? Cuz I've noticed the same thing that there's a very definite peak around 22 in terms of margins, in terms of earnings, in terms of stock prices and then >> it's run backwards since since then >> to today. I agree. So, so like an example would be Carters, right? They're the uh market leader in children apparel, baby apparel. Um they were crushing it after co, you know, everyone was getting their stimulus checks and they didn't really care if they were paying $10 or $12 for a pair of pajamas. Um so they were able to raise prices and and not only did they have some volume growth, they had the pricing power and all of a sudden they were they were making considerably more margin and and cash flow and profits. they start buying back stock in the 80s, $100 stock, you know, it's just booming. They're making$878 a share in earnings. Um, and then the the the COVID stimulus went away, the inflation hit. Now young families are having to decide between, you know, paying rent and buying new pajamas. >> Yeah. >> And the the decisions a lot more >> student loans they got to pay now where they weren't before. >> Yeah. So now you're like, "All right, I'm going to pay rent and now no pajamas for Timmy." And um so now their earnings are probably $2 $3 a share. Stocks at 25. Um and a lot of companies did that especially on the consumer side. They extrapolated that boom. Uh transportation did it too. And now some have gone bankrupt. Uh most are in recession. And it's an area of the economy that um I think illustrates what's going on with the consumer. you know, the the the uh difficulty they're having making ends meet and and especially on the discretionary spending, but even food. I mean, even staples now are getting hit by uh the I call it the affordability crisis. Everyone's focused on inflation, but the companies will tell you it's not inflation. It's the inflation we already had. It's the 30% p, you know, lower purchasing power or cut in purchasing power. And it's affordability that's the issue. And they're not addressing affordability. I mean, the inflation rate's at 3.1% now on the core. They reported today, and we're actually talking about cutting interest rates when the biggest problem, if you do a survey, it's the cost of living. And they're going to cut interest rates in this environment. Stock prices are at all-time high. Home prices are at all-time high. Cryptos are 4 trillion market cap. Um, I could go on and on. Credit spreads are so tight, corporate bond markets on fire, and we're cutting rates in this environment. I mean, it is insane, you know, and and I just I don't get it. And it's it's like, what are you doing? You know, the the populist is going to vote everyone out. They're going to give, you know, won't say that. All right, I'm going to back up here. Um, but they're going to vote him out, right? And they're going to they're going to bring someone in that's going to um redistribute the wealth. And you can't blame them. >> I said no rants, Toby. I'm sorry. >> Welcome to rants. Other than that, how was the play, Mrs. Lincoln? >> I love the Fed. The reason we love the Fed is they always screw up. You don't know when, but when they do, it's so bad. And the opportunities are so wonderful. And this is this is going to be one of the best cycles ever for patient investors and disciplined value investors, which we talked about earlier. There's probably about 14 left. Um, it's it's going to be great. So, I you know, I like to I like to rail on the Fed, but at the same time, you got to appreciate what they do in the volatility they eventually create in in the aftermath that will help us and our clients um hopefully make some money. >> I think Pal's done a reasonable job. I think that the problem was that the three lunatics who preceded him who have created the you know I think um Bernani certainly was probably the worst of the lot but then Yellen's just continued everything that Bernani did and Pal's been the first one to raise rates even though he's probably done it too slowly but if I understand that people use the 2-year as a reasonable proxy for where the the Fed funds rate should sit and pal I think has tracked it more closely than anybody else even though he's a little bit below through the entirety of the the 2020 recovery. What do you think? >> Well, I think you know in 2018 I thought the same thing and he started to raise rates and it looked like he was going to try to normalize the balance sheet and then stocks fell 20% and he >> he flipped so fast. >> Yeah. >> Um stopped raising rates started to QE again. and they called it something else. And um and then during co every company we were following practically was clearly clearly forecasting higher prices. Their costs were going up. We wrote about it a year before and it just was so obvious and I just we couldn't believe the Fed was was still at zero and they were still printing money. I mean it was crazy. >> What are all these years doing there? >> Yeah. 9% inflation and then you know everyone says what's going to bring down this this market cycle. I said well I thought 9% would have done it you know of an inflation but it but it didn't. Um so I I think he started out with good intentions and I think all the central bankers probably have good intentions you know but no one wants and it's not his fault that he's in this situation you I agree. I think Bernanki was the godfather. I mean, Greenspan was he was horrible, too. But but at least he never printed money, right? Bernanki printed money thinking that was actually a solution to our problems. Uh which every central banker that studied history should know that is the last >> he studied history. He was an expert in the Great Depression. >> Yeah. When people talk about housing now and I'm like I would because we sold our house in the bubble and I would sell it again if I wasn't if there wasn't money printing, you know, but it's so it's such a big risk. uh to to sell and rent right now because of the fear or the real possibility of them resorting to QE. Um which they might probably going to have to do at some point. Um so anyways, I was a fan of Pal also first. I think he tried to do the right thing and then when he saw, you know, like whoa, you know, I can see how this could all unravel pretty quickly with me, you know, trying to do the right thing. He backed off and now he's just trying to make it to the finish line and I think he's gonna make it. Uh but just like Greenspan, Greenspan made it to the finish line and still got blamed for the housing bubble. I think I think Pal who printed more money than any US central banker in history will also get the blame when the >> on partial off a higher base. >> Yes. Yes. And but I agree with you on Bernanki and Yellen just kind of she didn't want to do a whole lot of anything. She's just like, "Whoa, I'm just going to not do anything and see if I can get through this." And she did. You know, credit to her. So, uh, yeah, it's it's been a it's been a fascinating central bank kick the can. Uh, you know, it's just like a it's just like an average banker. When you have bad loans, how do you how do you not let bad loans go bad? You write more bad loans. So, so it, you know, it it creates a perception that as a percentage that the loans aren't so bad. Uh so so uh they're just going to keep it going until something snaps. Do >> you know the thing that amazes me is we're still we've still got a 103 inversion. You know that started in it's started in 22. We got very inverted. We've been inverted for a very long time and then it's been basically at zero or slightly inverted for the last like 18 months or something like that. So we're now like three or four years into this inversion. >> Is that a record? It's a record in the data that we h that that they have on the Fed website, but I've heard from uh I just I'm forgetting the forgetting the the firm name, but I Adam Butler and co said that um >> yeah, just has longer has a longer history that shows that there have been very long inversions in the past >> in the last likeund since since 1900 basically. Yeah, the long end's interesting. You know, I think the 10 year now is a little over four and the the 20-year, you know, is like 485. So, you could still get a decent absolute return yield if you'll take the uh maturity risk. You know, it seems 5% for the Fed is a scary number. You know, they every time we get close to exceeding that on the long end, you know, it's like it seems someone seems to be on top of that making sure we don't break out there. So, uh, that's a hard number or interest rate for us to afford and I think the government's very aware of that. >> It's been up every single year since 2020. I' I've plotted out that the curve since 2020 and it's been up the long end has been up consistently every year by a point or so, including like 24 to 25. The front end has moved all over the place, but >> it's the long end hasn't looked back at any point. I don't know what they do about that. if they need to do anything about it. >> I mean, what was the 10 year when the Fed cut last year? It was three something, you know. I think it's up. I mean, I'm not positive. 50 75 beeps. I mean, I don't follow the tenure too closely, but I know it's up quite a bit. Um, so I think that may have caught them off guard where like, whoa, we lost control of the the long end here. >> Well, certainly mortgage rates haven't taken followed their the the pi piper tune. And what happens if mortgage rates do fall? Uh what if they do cut rates, let's say, to zero, and mortgage rates go back to 3 to 4%. I mean, you should see a million-doll home around here. It's like, so what, you know, and then and now you're going to drop rates, you know, and and and spur the housing market again. You know, that goes back to affordability. And I don't think you're doing anyone any favors uh except people with paper assets. But I don't think it helps much either because there's a lot of selling pressure that's going to come through from the boomers downsizing or you know shuffling off this mortal coil over the next 20 years. >> There has to be Well, there has to be buyers on the other side. It's not going to be Black Rockck. >> There has to be some young family somewhere, >> right? >> Thank God for Black Rockck keeping those young families out. >> Yeah. Well, going back to Carter's, you know, one of the headwinds they've had is the birth rate. Um the younger generations can't afford to have kids. I mean, it's kind of sad when you think about it. If you want to talk about the consequences of easy money, I think one of them is clearly there's less babies. Um, so that's not cool, you know. So, uh, yeah, that's that's going to hurt a lot of things going forward. Population growth is is going to decline. Um, well, plenty of money and plenty of paper money, but fewer fewer people to make goods and services. >> Well, surely surely if you can print wealth, you can print babies. I mean, this is >> You would think. Well, AI might fix that somehow. We'll see. They might not be humans, but >> what's um what's interesting in small cap land in terms of uh industries? What do you think about energy? >> Uh we bought our first energy stock last quarter, uh Cord Energy. It's an EMP out out in the uh out in the Bakan. And um so, you know, we valued it about $139. We're trying to value the uh the cost of the reserves in the ground, which we believe is about $15 a barrel, has over 5% dividend. You know, that one of the things I like about energy is how they've been so disciplined with cash flow. And um I thought at first cuz most of the time I've been in the industry, you know, since the early 90s drill, they all just drill drill drilled, you know, regardless they got paid on production growth. But over the past 10 years, they've done a really good job. Uh but when when oil prices got down, you know, in the 50s, a lot of the EMPS started to sell near replacement cost of the reserves. Uh so that was that got very interesting. We're able to pick one up there. U so we like energy u not all of them, but we like certain ones, especially the ones with better balance sheets. Some of them because they have been paying out dividends and buying back stock don't have the best balance sheets. So we're we're we're really careful there. Uh we like transportation. We like the trucking companies. We own H Heartland Express. Uh that's old school value stock that's gotten absolutely destroyed. Um so we like companies that are already in recession and and that's a great example um with with the trucking companies. This is the third year that they've been in recession. Uh the business and the industry and uh we're avoiding companies that are doing really well. You know the opposite. >> Me too. That's their stocks too. So it's uh it's been a it's it's been a lot you we talked about this earlier. It's been a lot like 99 where we're buying really out of favor names that the stocks are in decline, the flows are horrible. Um the earnings are declining, but you know, that's actually when you want to buy cyclicals when things are bad and getting worse. Um because the stocks when you get them cheap, you never you're not going to get an energy company cheap when oil's at $100 a barrel. Uh you get it cheap when it's at 50. So, uh painful operating results right now for a lot of these companies, but some are stabilizing. We also like companies right now that are intentionally shrinking. Hartland qualifies for that too. They're actually shrinking their fleet. They're getting very little in capex. Their depreciation is 160 million a year and their net capex this year is going to be 40 million. So you're getting 120 million free cash flow by breaking even, right? And this is on a 600 million market cap. >> So they're they're generating plenty of cash flow. They actually bought back a million shares last quarter. U we own Monroe. They do uh auto repair shops. That's another one that's shrinking. They closed 145 stores. They have they have over 6% dividend. They've generated a ton of cash even in this period. But but the consumer is cutting back um on maintenance on cars. So, uh you know, just be careful out there. You see a car, you see an older car, it might not have brakes, you know, so might have bald tires. So, beware. Uh but people are deferring those. We can only defer those for so long. And uh but yeah, business has been poor for them, but again, that's a consumer discretionary that's not really discretionary, but that's that's when you want to own those, too. Uh but their comps have turned positive recently. So So we're we're hopeful there. So companies in recession, companies in recession that are stabilizing, even better. Companies in recession, stabilizing, they have good balance sheets, even better. So that that's kind of what we're focused on right now. >> Energy versus the market is as cheap as it's been. only two times cheaper were 2020 and 2000 to >> in this environment. Wouldn't you kind of want to own something that's tangible at a discount to replacement cost? I mean, I I find that attractive. We we own a farmland re too farmland partners. M so uh if I can buy acreage of farmland at a discount or uh reserves in the ground at a discount or even a um you know some receivables we own uh Kelly services the temp agency the receivables are at a discount to market cap u yeah that's great we love asset heavy companies right now too that that are selling a discount to to tangible book >> let me give a quick shout out and then JT you want to do some veggies >> yes sir >> senator Domingo, what's up? Danny Valareerezo, what's up? Mac Tallahassee, Dead Cat Gully, Andra Pradesh. Uh, Jupiter, Florida, Cincinnati, Boisey, Budgy Smuggler, Les Les Wan, and Budgy Smuggler Australia. Fairfax, Randall, Gerard's Cross, Main Streets of Gerard's Cross, emphasis on Main Streets, Brandon, Serbaton, Madira Island, Portugal, Toronto, and John Battle gave us a $50 tip. Thanks, brother. Appreciate you sponsoring the veggies. >> That's >> today's veggie sponsor is John Battle. That's a brand new thing we're doing just today. >> Yeah, we just thought of it. Better give him a rebate. [Laughter] Corvalis Oregon last one and then we we'll come back to the question. JT four is yours. >> Yeah, you guys did an amazing job uh team things up with the first part of our discussion as you will as you will see totally unbeknounced. Uh so imagine you're standing on the deck of a wooden ship in the Arctic and the air is stinging your face. It's so cold. It's the spring of 1674 and you've been sailing for weeks through this shifting ice. Your supplies are running low. You probably have scurvy. The men aboard are restless. And Ernest Shackleton won't be born for another 200 years. Then someone shouts, "Land hoe." And you squint toward the horizon. And there it is, an island fortress rising high above the sea, complete with jagged cliffs and snowy mountain caps. It looks so close you could almost throw a rope to it. And the crew cheers, of course. At last, we found salvation. You steer towards it for hours and yet as you're getting closer, something strange is happening. The island doesn't grow larger. If anything, it seems to be drifting further away. And eventually, you realize the terrible truth. There is no salvation. What is going on here? Is this just a sailor story like mermaids or the kraken or a superstition like you should always step onto a boat with your right foot? Uh, no. The reality is the sailors did see land, but it was actually a mirage. And in fact, you guys might not know this, but there are two types of miragages, superior and inferior. And you've no doubt seen the desert image, which is uh you know, the desert mirage, which is that shimmering pool of water on a hot road. That's the inferior mirage. The superior mirage is different. And and here's how the physics of this works. Light doesn't always travel in a straight line. In in uniform air, yes, but the atmosphere is rarely uniform. Cold air is denser than warm air and density changes how much the light will bend and a property that's called refraction and this is why things look closer underwater when you're viewing them from above the surface. So under normal conditions warm air sits near the surface and cool air above it. You know think about the temperature up at the mountain top compared to down in the valley below. In these normal conditions, the cold layer is above the warm uh and that light then bends only slightly and the world appears where it really is. A temperature inversion which is not to be confused with Toby's rates inversion uh flips that layering. Uh the cold dense air is then near the surface and the and then on top of that is the warmer lighter air. And when that light from a distant object enters this inversion, it curves downward towards the denser air before it reaches your eyes. So your brain, which is assuming that light moves in straight lines, interprets this as the object being higher than it really is. So this temperature inversion is common near the Earth's icy poles, right? Because it's very cold air uh off of the snow. Um and the result is these superior images is that objects are hidden by the curve of the Earth. They seem to float above the horizon. You're actually can see things like over on the other side of the horizon. So mountains that are hundreds of miles away uh you know appear to be rising into the sky in front of you and phantom ships may be sailing you know beyond where you could see like there they are and even coastlines you know seem to be hovering in midair and and the images actually aren't fuzzy sometimes they're often sharper than real life because the air acts like a lens uh and like zooms in a little bit and this is most dangerous part uh is that it's incredibly believable that this is actually there and historians speculate that the Vikings ventured to North America sometime around 1000 AD after spotting a superior mirage of the mountains of Baffan Island from the coast of Greenland. So they're almost like peeking onto the other side of the earth uh because of this uh and it looked to them like the land was much closer than it actually was. So then like okay let's set off and go explore that. So of course you know the the cousin in in the desert of the Mirage is is the in the inferior one and it works in reverse. And here, heat near the surface bends light upward, which makes the sky actually reflect off of the ground, and that creates the illusion of water on a scorching road or or pools shimmering in a, you know, a a false Sahara oasis. So, let's see if we can torture this analogy into something useful. In the Superior Mirage, your eyes aren't really lying. They really are receiving light from something that's real. The problem is your brain's interpretation of it. And that bending of light through layers of air makes the horizon look much closer than it truly is. And the closer you think it is, the more confident you feel steering toward it. So I can't help but think that that might be where AI is today. So uh the cold air is the hard, you know, measurable progress. These frontier LLMs are scoring higher than 90% of humans on specific tests. Automated uh coding assistance helping, you know, save weeks of development time. these AI agents that are boosting productivity in narrow domain domains. Um, and those are real tangible wins. Like that's the island on the horizon. The warm air might be the capital markets and the media layer kind of above that. You know, the trillion dollar TAM slides, the breathless coverage about AI replacing entire industries next quarter. Uh, stock market pricing in decades of compounding before any cash flows arrive. Half the workforce is being laid off by Christmas. uh you know that speculative heat refracts our expectations bending the arc of reality so that 20-year payoff looks like it's two years uh you know away isn't an inevitable thing. So uh you know these these mirages are then precise enough to tempt people into misallocating their resources. So they set sail they burn precious time and fuel and and when the illusion fades the true distance finally is it real reels itself as being greater than than ever before. So, who knows like maybe the real breakthroughs might be uh you know a decade away but the Mirage convinces us to act and spend as if the miracle is right around the next bend. Um and so just like those those Arctic sailors like we might get there eventually but and the land is real but the timetable probably isn't. So that's why, you know, I when I've recently was reading a headline that Meta is tapping Pimco and Blue Owl for I think it was $29 billion of debt for data center projects. Like that that's a little concerning. Like you tapped your balance sheet, you took a bunch of cash out, now you're going to, you know, lever it up to keep going. Well, that that implies then that there's a time period that you need to reach shore by. And that that can be difficult. Uh, so I don't know, Eric, is there are there any signs that you see today that kind of rhyme with the.com period when it comes to this, you know, the future being out there beyond the horizon, but it looks closer than it really really is. >> Yeah, of course. I mean, u it's feeling more and more like 99, you know. I remember 99 still very well. I was a young manager. Um, and and it just felt the same where you just felt like an idiot, you know, and you're missing out. It was very hard. Uh we were talking earlier about that's when I went and enrolled to graduate school because I I thought, you know, I I didn't know what I was doing and my career was over. Um but of course it all and this was what I don't think people really appreciate. Uh the the internet bubble popped without warning. Uh you know, I think everyone thinks that there's going to be a bell that rings. They'll have time to reallocate capital. And even though they probably know right now they're they're checking, you know, chasing a speculative bubble, they think they they won't get hurt because they'll be, you know, smart enough to get out. But I remember one day just coming into work. It was March of 2000 and it just crashed. I mean, these internet stocks crashed. So I think there's a lot of similarities right now, but uh investor complacency is probably the biggest and and the feeling again of of when you're not participating. uh you know I was a lot younger then so I I I thought I was a lot smarter then you know so it was I think it was harder for me than the 99 bubble um because I went from feeling so smart to so stupid that was that sort of transition was really hard for me personally but this time around I mean it still is horrible I mean I I hate I hate not participating it's you know we we want to be fully invested you know we really do we want to be making money we we would love to be making 20% a year on the QQQs and compounding that. I mean, just for one second, try to imagine being invested in the Mag 7 over the past few years. You go to bed, you're so happy about making how much money you made, and then you start thinking, well, how much are you going to make tomorrow? I don't know. I can't wait. You know, it's going to be so awesome. So, >> and they're great businesses, too. >> Yeah. They're such great businesses. It's so easy to be invested in. >> Yeah. And take that feeling, Toby, and then the inverse of that is what we're experiencing. >> And they're terrible businesses. The businesses that we're invested in deserve everything they get. >> But here's the bright side is when it ends, and it will u the feeling of being an idiot, uh, and then transitioning to to feeling the that vindication feeling. And you know, you know, we don't really care about relative performance, but when you outperform by thousands of basis points is pretty cool, you know. So, the the other side of this is uh is amazing, but making it all in one piece and maybe with a business, maybe not, you know, maybe with some clients, maybe not. >> Um it can be wonderful, but I I think at this point in the cycle, um there's there's fewer and fewer professional managers willing to do it. And one thing I would note about 99 too, this is very important. A lot of value managers portfolios did their own transition to try to participate somehow some way and they they did it by buying those stocks that maybe were they tried to classify its value. They tried to still hold a value category but still cheat kind of on the side. not cheat's probably a wrong word, but give in a little bit on principle to participate and you can understand that, you know, to try to to keep your job and and keep assets. Um, so you can still be value but not really be value. So you be really careful right now if you're a capital allocator, look under the hood and if you see a value fund doing really well right now, uh, especially on the small cap side, it might be a red flag. uh might might not be it might be an incredible stock selection, but a lot of the the uh genuine small cap values we believe uh have horrible charts right now. You should see when we when we're looking for new stocks and we see a horrible five-year chart, we're like, "All right, that looks awesome." You know, that's what we're looking for. Look at this. >> Yeah. Oh, give me an ugly fiveyear right now. Um but a good a really strong performing fund right now will have some really pretty fiveyear charts. So, I think you want to be careful of those. Do some do some research, deep digging there, and make sure that there wasn't a shift in philosophy or process and strategy. Eric, if you were an allocator right now, how would you how would you try to untangle luck versus skill, especially if you had a 10-year track record to look at, let's say, which sounds wrong, but >> yeah, but you know, even a 15-year uh Jake, now uh 10 and 15, 5, 10, 15 all tell you to allocate to the S&P 500. Um, and how are models made? How are capital allocations modeled made by looking backwards? So, everyone's like, you know, oh, small caps are going to come back. are so much cheaper. You know, I don't know if I would agree with that because if you look backwards, uh, all the numbers tell you to buy large cash and that's how these capital allocations are made. The pretty pie charts that you get when you go to an advisor and they tell you how they're going to chop up your portfolio and where it's going to be, the the numbers will tell you to be in large caps. And until that changes, and that this is another thing that was similar to the late 90s uh 2000, until the large caps get just destroyed and those backward-looking numbers don't look so pretty, the small caps are going to lag. But once that happens in 2000 to 2002, small cap value stocks had very very good gains. U but the uh large caps, you know, in the NASDAQ was down what, like 80%, something crazy. Uh so you were able to make money in a severe bare market by by doing exactly that kind of buying what's out of favor before the bubble before the bubble pops. So so you want to be very careful right now because I think most allocations would suggest to to to go with what's done well and it hasn't done just as well for a few years. So they can justify it easily by saying it's been 10 15 years. Uh that's a hard number to dispute versus a 2 year 3 year four year number. Because the cycle's been so long, you really want to be careful because we haven't had a real recession, a real bare market over that period. You want to be really careful now using long, this sounds weird, but you want to be careful not to use long periods of time to make investment decisions. And Eric, when you have a when the world is such where you know buying every dip has worked um the belief in the superpowers of central bankers and governments to do whatever it takes to you know uh keep keep corrections from happening. What does it take like an 80% down to disabuse people of the this kind of Pavlovian dip buying that they've been, you know, so wired to do over the last 15 years? >> I think so. And and there was an article in the Wall Street Journal, I think it was yesterday, talking about younger investors and how they've been able to u buy the dip and have been rewarded. And um it really was a this time is different article. Another one. I haven't had enough of those. Um, so I I do think, you know, as I learned in in the '9s, you know, that wasn't that smart or wasn't as smart as I thought I was. I think that's part of growing up as an investor, especially for the younger generation. But right now, you can't blame them for thinking they're invincible and, you know, they can they can make money so easily. I mean it really if if if we wanted to make money even in our fund right now I think we could do it and I think we could make a lot but I also think we would be setting ourselves up for losing a lot of money you know so uh and you can't I'm telling you you cannot you will not be the person that gets out first I mean if you do you'll be very exceptional timer and we're not market timers but uh you know the risk right now especially on the large cap side and I'm not promoting small caps I don't we don't think small caps are particularly cheap u but they are getting cheaper and there are more things to work on now which is great but as far as the large cap side of the market I mean and back in the '9s too you had Gillette Coke you know 30 50 times earnings those got destroyed and people people they they think because they're in high quality they're protected that's not true you know Costco at 50 times earnings could easily lose half of its value easily um so people need to be be aware of that as well that that quality is not panacea >> a perfect a perfect way to control risk. It's valuation is much more important. >> I got a good stat uh from Twitter. This was a Bank of America global investment strategy. US large cap annualizing $419 billion for 2025, which was the second highest ever to 2024. US small cap annualizing $80 billion in outflows, which is a record. Go small cap. I was amazed that they had that much to lose. >> Yeah. They're all that's just all wiped out. >> Well, what what is the Russell 2000 ETF? It's like 10 billion maybe. I really don't know. But but the but the uh >> I had a look at IWM. IN. >> Yeah. One of the NRM. There's two of them. There's a value in >> it's 4.4 billion. >> Oh, it's embarrassing. and the and the uh the Vanguard or you know whatever it is and >> Vio >> what is that I mean it's several hundred billion I think >> and you know in in the big active funds now you look at let's let's and I don't want to get sued here so I gota be careful let's the contra fund there's a there's a fund out there called the contra fund I won't >> who knows what what what does contra imply to you maybe contrarian >> you know on Twitter a contra is someone who you trade against But >> it does it does sound contrarian. That's right. >> Back in the day it meant contrarian. I don't know what it means now because if you open the hood of that portfolio, it it's like the mag seven fund, you know. Um so so even the active managers I think have figured out, you know, if I don't own the big weights of these names, you know, we're going to risk uh underperforming and risk losing assets. And the fund has done incredible but and so is the assets under management. So, uh, I think if you overweight some of these names doing really well, like we said before, you can there's a way to make money right now. It's pretty easy and that's to play along. And if you want to leverage that up, which, you know, we have the leverage ETFs now, we have options. A lot of people are doing that. So, it's not just buying the S&P or the QQQs. They're uh they're going even further than that. So, uh, it's and those flows are huge, Toby. I mean, I remember back in the in the '9s when we had your 2000, there was like 50 billion inflows and everyone thought that was nuts, you know. Yeah, now you know now we're talking hundreds of billions um going into these ETFs and passive funds. So >> there are a lot of companies that have stumbled over the last even in even in large cap land. I think it's kind of interesting that that it is so concentrated into a handful of names that are performing. I don't know if it's 10, but it's it's certainly in the top 100 and then the 490 or the 400, however you want to break it up, they they really haven't done very much. They've been basically also flat since two 2022. >> It's really only a handful of names that have been a beneficiary of that capex AI spending. >> Yes, exactly. >> That have done well >> through this period. And a lot of that is like >> as we were talking about it's hard to they're deploying so much money like the returns that they have to get out of that money that they're deploying are becoming like they're equally astronomical on the other side to justify it otherwise. and the the I I sort of equate it to like a 99 uh fiber optic cable buildout. And that's not that's not an original thought, but it's but it's a common kind of analogy to make. The difference is that the fiber optic cable goes in the ground for 25 years. Whereas the useful life on these chips like 3 or 4 years before you get another like are we going to be spending at this sort of rate all the time? Like is that just what we're doing now? >> And yeah, how's that sustainable? You know, I always joke about the tech bubble. You know, at least we got the internet infrastructure for that. That was cool. And then the housing bubble though, I go, what do we really get out of that? And then I was like, granite countertops. Everyone got new granite countertops. >> Yeah, it does feel like there's a obsolescence like, you know, I mean, let's rewind even further back like railroads, the you know, huge capex boom. I think it was something like 6% of GDP was being spent on capex during the railroad boom. Well, you know, some of those rails obviously they've been replaced, but the rideaways are the same as they were 150 years ago, right? Like that's right. >> That's really you you advertised that cost. Well, >> but yeah, chips at, you know, let's be generous and say five to seven years even, which I think is what they're they're doing. >> Yeah, but but the ones they're putting in now will probably be obsolete in 18 months, right? >> Yeah, maybe. >> It's great for Nvidia for >> Yeah. I don't know if the customers can keep up with them. >> Well, and in fairness, my understanding is that those those chips they then sell on to like the inference side where you don't need quite as much horsepower apparently. So, it's not like a total like you write zero. >> Well, yeah. I don't know. So, they're not like zeros, but like yeah, the the training chips have to be quite the most powerful apparently. So, those are the ones you got to replace every three years. Are we getting >> this is why we uh we we we do avoid a lot of technology stocks and not because they can't do extremely well, but because they're just hard to value. I mean, we're talking about this right now and none of us can really quantify what cash flows are going to be in year five, you know, let alone year one or two, right? So, it's just so hard to value and u you're not buying a perpetual bond. You don't really know what you're buying. um it's just a tremendous amount of investment with with uncertain returns and that's more of speculation and it could work great. But for us, you know, if you're just kind of discounting a long-term bond sort of investor, those are really hard to uh plug in a model. >> Yeah, you want some steadiness. It seems like energy is not going away anytime soon. I think energy is a reasonable bit. I also saw healthcare is doing underperforming the S&P 500 by the most since 2000. >> We just bought our first uh healthcare device company um maybe I mean in a decade maybe since we since our inception I know but yeah you're right those have been under pressure uh so that's interesting you bring that up we've noticed that as well. Um, one thing I want to talk about which we haven't is is tariffs. You know, we had the CPI number today come in and I I think the the main number was lower than expected and the core number was a little higher. But a theme I wanted to talk about in the quarter was a lot of the companies we follow are uh haven't um reported a lot of impact from tariffs at this point, but it's coming. You know, I mean, it's definitely going to I just want to be aware of this. Well, we should set a little context too, uh, Eric, that, you know, you do a ton of bottom up reviewing of >> I think hundreds, right, of earnings calls that then like give you kind of a bottomup economist viewpoint of the economy. >> Yes. Sorry. >> Exa Exactly. Thank you. So, so we we'll get a feel for what's going on with the companies. And I remember in in, you know, kind of 2021, uh, we were seeing inflation coming, I mean, straight on. And uh it was very obvious to us uh and this is another one of those moments where we see it again. There's going to be a lag, but it it's coming. Uh you know, there's there's three things companies are doing. One, they're raising prices. Uh two, they're trying to pass it on to vendors in the supply chain somehow. And the third thing is they're cutting cost. But almost all the companies we follow intend to mitigate 100% of the tariffs. So they're not going to absorb it. um they're going to use prices and someone else is going to absorb it a and they're going to do productivity cost cutting. So this will have an impact I think late this year definitely by 2026 inflation numbers will go up especially on I mean it will go up on goods and goods for sure we we believe uh so so just keep a look even though we haven't really seen it yet it it's in the pipeline u companies when this all started happening in April they kind of all froze none of them really knew exactly what to expect or the real numbers to use so they couldn't do anything but now they have more clarity they're taking action u and this could affect jobs as well uh later this year, early next year as again they're going to cut they're going to cut costs or try to improve productivity. Another thing I like too is a lot of them are going to uh re-engineer their products. So they used to call it lightweing, you know, get less, you know, and then the whole strengthflation theme came out and people made fun of it on the internet and so now they no longer call it lightweing. They call it re-engineering, which sounds a lot better, you know. Hey, I'm not getting ripped off. the the re-engineering that's gonna make it better. But uh >> we re-engineered this bag of chips to have uh eight chips in it instead. >> Exactly. So, you know, we follow an apparel company. They're re-engineering shirts to have less cotton and and they and they they spin it. Oh, it's it's much bre it's more breathable now. >> Yeah. At some point, we're all going to be naked because of all the re-engineering. But so that that's another thing to watch for. uh you'll see changes in packaging and and product offerings and how they were made. So uh so yeah, it's coming. So so there's no free lunch. >> The thing that I don't understand that seems like you know if you just think about like you ask yourself and then what you know one time on this okay we've got like huge margins um known cost pressures coming from tariffs just even having to just write the check to the government for to get something inside the the the the borders of the country. Okay. And they're all saying they're going to be passing this along. But isn't there one company, two companies that would defect and say like, well, you know what? I want market share. I'm not going to I'm going to eat my margin that I had. I'm going to pay this and like I'm going to pass this savings on to the consumer, which at some point that's what technology has meant like it's, you know, we we all have more from doing with less input. um you know at some point like where is the game theory of the competition of between businesses to lower or not raise their prices commensurate with the tariff expense? Well, you know, especially with small caps, a lot of these companies are already under margin pressure uh with with rising costs. You we talked about trucking earlier. It's not just demand, but they have a lot of their costs, the labor especially, and the equipment cost, replace equipment that's going up, insurance is going up. So, you have a double whammy right now with the costs are rising. So, now you throw the tariffs on that too. It's really going to be hard for them to uh to eat it right now. Just the way things are going for and Toby, you talked about this earlier with the S&P 500. you know, the 400 or less, you know, are actually not growing very very well right now. So, it's just a hard time to ask someone to a business to eat it. Um, but in aggregate, you're right. I mean, the profit margins you would think would would somehow come down and but um that's being skewed by the mega caps. Um, one thing real quick on inflation I want to discuss too, um, is a theme we're seeing too with companies and that is a premiumization where they are selling more towards those that have benefited from asset inflation. And I think that's really um something that, you know, we talk about one times with the tariffs. Something that's not one time until stock prices and home prices fall is this trend towards selling to the wealthy. and they are more uh lately been more impactful in setting prices than the lower end. Um so you have two economies. The high end that's willing to pay anything and the lower end where where they're where they're buying less u trading down. There's two things going on. But as the as the wealthy uh get wealthier, they've been they've been more willing to pay any price really for you know you we went to Panera and I bought my daughter a small mac and cheese and a breakfast sandwich. The breakfast sandwich was tiny. It's like the size of an apple. The mac and cheese was this little bowl and it was $15. And I was like, "Are you serious? I How much is mac and cheese?" She said, " $7. I got I go to Publix and get a whole box for $2. >> There goes our Panera sponsorship." >> Yeah. But if But then I was thinking, you know, if I own the QQQ's and Max 7, you know, that $7 Mac and Cheese, whatever. >> Yeah. So they're setting the prices more towards uh the person that that is flushed with asset inflation versus the the small cap value manager. But so I do I do think that's really interesting. Um the price setting right now that's going on. You you saw it with Delta, right? Delta's premium seating last quarter was up 5%. Um nonpremium was down 5%. I think that's the perfect summary of the economy right now and the perfect summary of of what we're seeing with prices. So there'll be some discounting on the low end maybe. Uh but companies have figured out they're better off doing less and making more. Uh it's a theme they learned during co you don't have to be at full capacity to make money. You can you can do less, charge people more, make more. It's a lot easier. >> Hey uh Eric, we're coming up on time. Thanks so much for spending time with us today. But if folks want to follow along with what you're doing or get in contact with you, what's the best way of doing that? Uh palm valley capital.com is our website. So uh if you're interested, stop by and really appreciate you having me. I always enjoy our conversation. Um Toby and Jake. So uh until next time. Thank you. >> Sign up for Eric's blog posts. I read every single one of them. >> Thank you, Jake. We appreciate that. >> Uh JT, we got a great great quarterly letter, too. Jamie writes that. So I always I always like to plug that. That's my favorite quarterly letter out there. >> Q Q2 Q Q3 >> Q Y Yep. Q2. Check it out. >> No words of wisdom. I used all my wisdom already for the day. >> That's interesting. >> We'll see you next week. December time.