<October 24, 2024>
Last week I was sitting at a traffic light when a shiny new Corvette pulled up next to me. It was a sweet ride. I’ve always appreciated the power and look of Corvettes, especially the earlier models. However, I never considered buying one given the lofty expectations of being a Corvette owner. Put simply, I’m just not cool enough.
As I waited at the light, I wondered if the driver was who I expected. Of course, I shouldn’t stereotype. Nonetheless, to satisfy my curiosity, I looked over to identify the driver. And there he was, just as I pictured him—Corvette guy.
As the light turned green, the Corvette sped away, leaving me in the dust. At the next traffic light, I stopped behind a Subaru covered with bumper stickers. From “I climbed Mt. Everest” to “Who Saved Who,” the stickers touched on a variety of topics.
Before there was Twitter, there were bumper stickers. They’re a concise and effective form of communication used to express opinions and create awareness. According to Psychology Today, “Bumper stickers remain an unspoken form of social interaction…that offer a unique opportunity for people from all walks of life to share their views in a public social sphere.”
To illustrate the effectiveness and diversity of bumper stickers, I placed two examples below. Each sticker communicates a very different but clear message. After viewing, you’ll likely feel you've been introduced to the drivers and know more about them. You may even be able to visualize them in their vehicles!
Research has shown that experiencing discomfort can lead to personal growth. It’s advised to try new things, even if it causes pain and suffering. To that end, I’ve decided to put a bumper sticker on my vehicle. It’s something I’ve never done and never expected to do. However, in an effort to produce the necessary discomfort for self-improvement, I recently completed the process of creating and applying a bumper sticker.
The first step of selecting a bumper sticker is determining the topic. I decided against popular stickers promoting politics or sports teams. I wanted a unique message explaining something misunderstood. While brainstorming, one of my first ideas was the bumper sticker, “I Love Cyclicals.” Surely, there can’t be many of those on the streets!
Never in the history of financial markets has an investment presentation began with, “Hi, my name is Bob, I buy low-quality companies.” Instead, investment managers proudly pitch their portfolio of high-quality businesses. Of course, at Palm Valley, we love stable high-quality companies too! But we also love cyclicals, or businesses that generate non-linear operating results that are often influenced by economic and industry trends.
When learning the basics of investing, equity analysts and managers are typically taught a strict definition of quality: high returns on capital, high margins, consistent growth, recurring revenues, high barriers to entry, excellent management, and so on. We believe this definition is overly exclusive and limits opportunity.
In our opinion, labeling a company cyclical doesn’t necessarily mean it’s an unattractive business that should be discarded. It simply means operating results can be more volatile over a full profit cycle. If Company A (non-cyclical) and Company B (cyclical) both generate $100 million in earnings over 10 years, does it make sense to exclude Company B just because its profit cycle isn’t as smooth? We don’t think so.
Including cyclical stocks in an opportunity set has several advantages. First, many investors are unwilling to accept fluctuating and less certain profit cycles. With fewer investors considering cyclicals, their stocks often have more reasonable valuations and are more likely to be mispriced. Professional investors also tend to shun cyclical stocks, especially during periods of declining profits and meaningful sector underperformance (when they’re most attractively priced). The precious metal miners in 2015 and energy-related companies in 2020 are great examples. Although both sectors were extremely undervalued, their declining stocks created unacceptable levels of career risk for most professional managers.
Instead of avoiding companies with non-linear earnings cycles, we continuously search for high-quality cyclicals. Our focus is on businesses with dependable full-cycle profits that we believe we can value with a high degree of confidence. Including cyclical companies in our selection process increases the number of opportunities created by the natural ebbs and flows of profit cycles. In effect, rather than avoiding the earnings volatility that can dissuade many investors, we attempt to understand and profit from it.
While we love owning undervalued cyclical companies, there are some caveats. First, they must have strong balance sheets. It doesn’t matter if a cyclical stock is cheap if the business can’t survive a prolonged industry downturn or recession. Second, it’s critical to normalize profits when valuing cyclical businesses and refrain from extrapolating. We attempt to avoid getting overly excited during the booms and overly depressed during the busts. Lastly, operating results of cyclical businesses are more volatile, so it’s important to adjust required rates of return accordingly—demand more.
In summary, the key to making money in cyclical stocks is to own strong balance sheets, normalize earnings, and require an adequate rate of return. Our best results have come from buying when profits are depressed and declining. Rarely, if ever, has it made sense to buy cyclicals near the peak of their profit cycles, even though that’s when it’s most tempting and exciting to own.
As much as we love cyclical stocks, and the “I Love Cyclicals” bumper sticker, I decided to pass on the idea and did more brainstorming. I wanted to reach a broader audience and touch on more timely and urgent topics. Below are some of the bumper stickers I considered:
Ultimately, I decided on a positive and encouraging message. Specifically, I selected a sticker that supports the Federal Reserve and their momentous task of sustaining an economy dependent on debt, fiscal deficits, and another stock market bubble. I never thought I’d be a bumper sticker guy, but I’ve enjoyed the process and responses on the road. If you’re ever in the Jacksonville, Florida area and happen to see a vehicle with this bumper sticker, don’t forget to honk!
Eric Cinnamond
The Palm Valley Capital Fund can be purchased directly from U.S. Bank or through these fund platforms.
Index performance is not indicative of a fund’s performance. It is not possible to invest directly in an index. Past performance does not guarantee future results. Current performance of the Fund can be obtained by calling 904-747-2345.
There is no guarantee that a particular investment strategy will be successful. Opinions expressed are subject to change at any time, are not guaranteed, and should not be considered investment advice.
Fund holdings and allocations are subject to change and are not recommendations to buy or sell any security. Current and future portfolio holdings are subject to risk. Click here for the fund’s Top 10 holdings.
Mutual fund investing involves risk. Principal loss is possible. The Palm Valley Capital Fund invests in smaller sized companies, which involve additional risks such as limited liquidity and greater volatility than large capitalization companies. The ability of the Fund to meet its investment objective may be limited to the extent it holds assets in cash (or cash equivalents) or is otherwise uninvested.
Before investing in the Palm Valley Capital Fund, you should carefully consider the Fund’s investment objectives, risks, charges, and expenses. The Prospectus contains this and other important information and it may be obtained by calling 904 -747-2345. Please read the Prospectus carefully before investing.
The Palm Valley Capital Fund is distributed by Quasar Distributors, LLC.
Definitions:
Cyclicals: Cyclical stocks are securities that are heavily affected by the economic cycles and follow the ups and downs of the overall economy or an industry.
NVDA: The stock symbol for NVIDIA Corporation.
Zero days to expiration options: Options contracts that expire and become void the same day that they’re traded.
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