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Pint-Size Stocks Making Big Money


How one fund manager outpaces the market by thinking small.

Forget what the mainstream media has been shouting at you because here's the tough truth: Business stinks.

At least, that's what Eric Cinnamond is hearing from the companies he owns. Cinnamond is the lead portfolio manager of the Intrepid Small Cap Fund (ICMAX), which invests in companies with a median market cap of $923 million. Lately, Cinnamond says the news from these pint-sized companies has been grim.

"It is clear to us that we aren't seeing a rebound like the mainstream media suggests," Cinnamond says. "Most of the companies we follow aren't managing their businesses for an uptick in economic demand. They are managing their businesses for the current depressed environment. Nobody is anticipating an improvement any time soon. They have battened down the hatches."

Regardless of how tough things get, however, the 38-year-old Cinnamond has proven himself a nimble and smart investor. Though it's a young fund, ICMAX has handily beat the competition: Through September 2, the fund's three-year annualized return of 13.12% beats its Morningstar peers by 19.27 percentage points, landing in the top 1% of its category. Morningstar awards the fund five stars, its highest rating.

The no-load fund with $210 million in assets has an expense ratio of 1.95% and a minimum investment of $2,500.

Recently, Minyanville touched base with Cinnamond at his office in Jacksonville Beach, Florida. We chatted about what lies ahead for the small-caps, his investment strategy, and a few of his top stock picks right now, including Weis Markets (WMK), Constellation Brands (STZ), and CSG Systems International (CSGS).

Minyanville: The small-caps have had a good run. The iShares Russell 2000 Index (IWM), an ETF that tracks the Russell 2000, is up 54% in the past six months. Do you expect these strong gains to continue?

Cinnamond: Well, first, let's go back: from 2005 to 2008. Before the decline, small-caps were a joke. They were so expensive. Money was too easy. Then you had the gravy of the LBO boom, which drove these things up to insane valuations. That was, to me, an extremely difficult period for any sort of rational, fundamental investor. Then you had the crash where the Russell peaked around 850 and troughed around 350. Things were too cheap at 350.

And now?

Now it seems things are about right. Most of the new companies I work on are fairly valued. It isn't as excessive as 2007. So, yes, it had a huge rally, but it was a rally from under-valued to fair. But the fat pitches are definitely getting harder to hit. You have to look at 100 names to find one good idea. In March, it was like shooting a fish in a barrel. It was very easy.

Minyanville: If the economic recovery is disappointing, and bank lending is restrictive, won't those create big headwinds for smaller companies?

Yes, and that is why we try to never take operating and financial risks together. We are always concerned with small-caps being able to get credit. That is one reason we did well last year. [The fund lost just 7% in the market's 2008 meltdown.] In the decline, the stocks we did own had good balance sheets and they didn't need bankers or Wall Street.

Minyanville: Explain the fund's investment strategy to us.

Cinnamond: We are pretty steady-eddy here. We don't make a lot of mistakes. But we don't hit a lot of home runs, either. Most of the companies we buy or focus on are established businesses that have been around a long time and have been through many economic cycles. So we can get a good feel for what their normalized free cash flows are, and that allows us to value the companies with a high degree of confidence.

Why concentrate on strong free cash flow as a metric? What does that indicate to you as an investor?

Cinnamond: It indicates a good business. You don't see recurring free cash flows and strong balance sheets in low quality companies. We think quality resides in the balance sheet and cash flow statement. You can have low margins, low return on capital, and slow sales growth and be a good business. The traditional screens of quality are flawed.

You also place a lot of emphasis on a strong balance sheet.

Right, you usually get in trouble with an investment because of a balance sheet. Look at the newspaper businesses. We didn't own any of those, but that industry was in decline, and a lot of those businesses acquired and took on debt. They panicked because of negative growth, and took on leverage, and that was the end for many of them.

Minyanville: And a lot of them were looking cheap at one point.

Cinnamond: Yes, so it was tempting. But their strategies relied on debt to grow out of the decline in their core businesses.

Let's do some stock picking. You like Weis Markets, which operates retail food stores. How come?

It has a great balance sheet and a stable end market. They have about 165 grocery stores mainly in Pennsylvania, no debt, $112 million in cash, $800 million market cap, and 3.7% dividend.

Minyanville: Bears write that there's more competition for the consumer's food dollar with warehouse clubs and supercenters gaining market share over conventional supermarkets. Is that a concern you share?

Cinnamond: Weis Markets have 30% to 50% market share in most of their markets even with that competition. They are more of a 50,000-square-foot store versus a 100,000-square-foot super center where you're walking half a mile to get a gallon of milk. Weis Markets is selling to a completely different audience: They are more about freshness, efficiency, and convenience. You don't go to Wal-Mart (WMT) to get a good steak or salad. They haven't perfected that, and I don't think they can. They are just too big.

Minyanville: How about Constellation Brands? That's another one of your favorites.

Cinnamond: This is a good example where we will buy a company with debt so long as the end market is stable. Wine isn't growing as quickly as it was but it's still constant currency, growing 3% to 5% in the US. Their strategy is simple: Divest low margin, low premium brands, cut costs, and pay down debt. It's a strategy that is hard to screw up. They have $4.3 billion in debt and they generate $1 billion in EBITDA per year. They can pay down about $350 million per year in debt with their free cash flow.

Minyanville: Then there's CSG Systems International.

This is one of the more risky holdings we have. They do billing and customer services for cable and satellite operators. On one aspect, it is extremely stable because they have contracts with all these companies. But, on the flip side, they have very large customer concentration with DISH Network (DISH), Comcast (CMCSA), and Time Warner (TWX). I think Comcast accounts for around 20% of their revenues. They generated about $90 million of free cash flow last year on $500 million market cap. So, again, you get a very high free cash flow yield.

You also like a couple of miners: Pan American Silver (PAAS) and Royal Gold (RGLD).

We are not big macro thinkers. But we are very aware of what is happening to the dollar. So we are long precious metals. Our weight now there is about 6%. We never owned them in the past. But if I can buy silver in the ground and gold in the ground at a discount to spot in this environment, then I don't think that's a bad investment.

Minyanville: Thanks for your time. We appreciate it.
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