From May 1st market commentary by the Palm Valley Capital Fund (PVCMX) co-manager Eric Cinnamond.
Original blog post can be found here:
https://www.palmvalleycapital.com/post/undateable*****************************************************************************************************************************
Undateable
May 1, 2024
You can learn a lot about the financial markets by watching Seinfeld. In season 7 episode 114, Jerry and Elaine have a conversation about the lack of dating opportunities. Although they were talking about the percentage of people they consider dateable, by making some minor changes to the script, their conversation fits the current stock market perfectly.
Jerry: Elaine, what percentage of people [stocks] would you say are good looking [attractively priced]?
Elaine: 25%
Jerry: 25%? No way. It’s like 4% to 6%. It’s a 20 to 1 shot.
Elaine: You’re way off.
Jerry: Way off? Have you been to the motor vehicle bureau [screened through stocks]? It’s a leper colony down there [horrendous opportunity set].
Elaine: Basically, what you’re saying is 95% of the population [the stock market] is undateable [overvalued]?
Jerry: Undateable [overvalued]!
Elaine: Then how are all of these people getting together [why are all these people buying stocks]?
Jerry: Alcohol
As if our dating scene couldn’t get much worse, the S&P 600 soared 15% in the fourth quarter of 2023. Encouraged by the Federal Reserve’s year-end pivot, investors piled into stocks, attempting to front run the return of easy money.
At the time, we were baffled as to why the Fed was in such a rush to cut rates. For the most part, corporate earnings remained inflated. Financial conditions were already loosening, with equity valuations elevated and credit spreads tight. Home prices were also rising and remained out of reach for millions of Americans. And while the rate of inflation had declined, many of the items helping inflation moderate were plateauing, and in some cases, reversing. Further, accumulated inflation remained a serious problem, putting pressure on middle- and lower-income consumers and keeping inflation expectations elevated.
Unsurprisingly, by pivoting before the inflation battle was won, the Fed unleashed another round of asset inflation, bolstering demand and pricing power. Instead of declining back to the Fed’s 2% target, inflation bottomed and is on the rise again. To date, the Fed’s 2023 preemptive pivot is aging about as well as its “inflation is transitory” assurances in 2021.
Instead of declaring victory on inflation, we believe the Fed prematurely signaled rate cuts to head off building threats to asset prices and the economy. While there are many risks to defuse, we believe refinancing risk was, and remains, near the top of the Fed’s list of concerns. With each passing day, the amount of low-cost government and corporate debt nearing maturity grows.
Extremely low interest rates allowed the U.S. government to borrow aggressively, supporting massive fiscal deficits and artificially inflating economic growth. Corporations also benefited from elevated government spending and lower rates. Low-cost debt allowed companies to acquire, fund generous dividends, and turbocharge earnings per share (EPS) through buybacks and depressed interest expense.
As accumulated inflation continues to build, along with a seemingly endless supply of U.S. Treasuries, we believe the era of ultra-low interest rates has ended. With interest rates remaining higher for longer, a growing number of businesses are facing difficult refinancing decisions as their maturity walls approach. While some are pushing off the decision—hoping rates will decline—the market isn’t waiting and is beginning to sniff out companies that require funding over the next 1-2 years.
As we search through our opportunity set of small cap companies, many of the stocks that have performed poorly have bonds approaching maturity or have refinancing risk. For example, Cracker Barrel Old Country Store’s stock (symbol: CBRL) has fallen 45% over the past year and 61% from its 2021 high. Cracker Barrel operates restaurants that are typically located along interstate highways. We know their home-style country food well, as we hold Palm Valley’s annual founders meeting at a local Cracker Barrel (and yes, we all order from the value menu!).
Similar to many consumer companies that cater to the middle class, Cracker Barrel’s traffic growth has slowed and has recently turned negative. Accumulated inflation has placed stress on discretionary spending and many of the casual dining companies we follow. Management expects industry and traffic challenges to continue. Based on analyst estimates, adjusted EPS is expected to decline from $5.47 in fiscal 2023 (ending July 31) to $4.60/share in fiscal 2024.
Even as operating results have weakened, Cracker Barrel has remained committed to its generous quarterly dividend of $1.30/share. If maintained, the $5.20/share in annual dividends will exceed this year’s expected net income. The company has also been an active buyer of its stock, purchasing $184 million over the past three fiscal years (2021-2023). Combined, dividends and buybacks have consumed $447 million in cash over the past three years versus $461 million of free cash flow.
With practically all of Cracker Barrel’s free cash flow being consumed by dividends and buybacks, debt reduction doesn’t appear to be a priority. As of January 26, 2024, debt was $452 million. Based on 2024 estimated EBITDA of $242 million, debt to EBITDA is 1.87x, or slightly above the high-end of the company’s target range of 1.3x to 1.7x.
On June 18, 2021, Cracker Barrel opportunistically issued a $300 million convertible bond with a 0.625% coupon. At the time of issuance, its stock was trading at $150.51. With a conversion price of $188, the bonds had a conversion premium of 25%. Currently, Cracker Barrel’s stock is trading near $59; therefore, the odds of the bond converting to equity before maturity are low. With a maturity of June 15, 2026, refinancing will likely become an increasingly important issue for the company and investors.
Cracker Barrel has $511 million available on its $700 million credit facility that could be used to fund its convertible bond maturity. However, the weighted average interest rate on the credit facility is currently 6.96% versus the 0.625% coupon on the convertible bond. Assuming the credit facility is used to fund its bond maturity, at current rates, Cracker Barrel’s interest expense would increase $19 million, causing a meaningful hit to earnings. For reference, earnings before interest expense and taxes (EBIT) in 2023 were $120.6 million. Like many companies with debt, Cracker Barrel’s cost of borrowing has shifted from an earnings tailwind to headwind.
We classify Cracker Barrel as a cyclical business. To consider cyclical businesses for purchase, we require a debt to normalized free cash flow ratio of 3x or less. Based on our free cash flow estimate, Cracker Barrel currently has too much financial leverage for our absolute return strategy. Nevertheless, its substantially lower market capitalization has caught our attention, and we’ll monitor its balance sheet closely for potential deleveraging catalysts, such as a cut in its dividend or sale-leasebacks of owned properties.
The small cap dating scene remains unattractive, in our opinion. However, for many consumer discretionary companies with debt, equity prices have fallen sharply, and valuations have become more attractive. That said, these aren’t dream dates! Cyclical companies with debt often come with a lot of baggage and potential drama. Before committing and getting too serious, we recommend stress testing the balance sheet and cash flow by including periods with high unemployment and tightening credit conditions. And if alcohol is needed to stomach the risk, we suggest patience and waiting for a better match. When it comes to leveraged cyclicals, there are plenty of fish in the sea!
Eric Cinnamond
[email protected] 
Comments
And if you can't find a Ginger or Mary Ann, blame the Fed.
"Beer GOOGLs"
See the fund goals https://www.palmvalleycapital.com/goal
Risk defined as losing money
Flexible mandate allows for patience
No sector constraints
Elevated career risk
Independent; unique
Fiduciary duty uninhibited
Sounds like PVCMX is still having trouble finding many good values in this market.
I doubt Cinnamond ever finds much of any kind of equity that measures up to his standard. He won't even commit to the equities he does like.
Meanwhile, the managers you've never heard of that run VSMIX manage to find a few things worth buying--as do many others.
Throw PVCMX in with conservative allocation funds, like AONIX or FASIX, and he looks pretty good, despite the price.
Shoot, the standard deviation on the fund is right between RSIVX and OSTIX on my watch list, the beta is lower, and five year returns are better than either. That's nothing to sneeze at.
But that's not his shtick. ¯\_(ツ)_/¯
"Beer goggles" - used to refer to the supposed influence of alcohol on one's visual perception, whereby one is sexually attracted to people who would not otherwise be appealing,
when applied to financial markets becomes:
"Beer GOOGLs" - used to refer to the supposed influence of AI on one's analytical perception, whereby one is financially attracted to stocks that would not otherwise be appealing,
(all strictly in the spirit of this commentary, of course).
While a long-time fan of Cinnamond's fund management, I also own (a rather smaller) position in VSMIX. To be fair, VSMIX has had an amazing run over the last 3+ years, but it might be worth keeping in mind that on the 10-y basis it's posted max DD / alpha of < -47% / -3.70 under the same management per M*. On the flip side, I do not recall Cinnamond getting much below -20% DD in his entire managerial carrier across four different funds.
I began to appreciate PVCMX as an investment when I began to compare it to other funds with similar risk profiles, similar levels of commitment (there's that word again) to investing in equities, and so on.
I wouldn't pay what he's asking for, but I can understand why others might. And I wish y'all many hours of blissful slumber. It's a factor that deserves more appreciation than it gets.
It has been a tough row to hoe for small-cap value for many years. I would compare VSMIX to other SCV funds in that regard. It seems to have been quick out of the gate in relation to changing conditions these past few years.
However, calling PVCMX a SCV fund is like calling FAGIX a LCG fund. It just bugs me for some reason.
If Cinnamond seriously considers that vapid conversation between Jerry and Elaine as a useful analogy for describing any part of his investment philosophy, well, God bless him; I don't think he got the joke.