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Waiting to Pull Up Anchor

Small caps have reached the top of their cycle, manager Eric Cinnamond says. He’s hoarding cash for when the market turns.

Michael Brennan, 06/17/2013

This article originally appeared in the June/July 2013 issue of MorningstarAdvisor magazine. To subscribe, please call 1-800-384-4000.

By at least one standard, it might be difficult to be Eric Cinnamond right now. The brains behind River Road Asset Management’s small-cap strategy, which fuels ASTON/River Road Independent Value ARIVX, spent the winter watching mostly from the sidelines as the Russell 2000 Value Index posted scorching returns. After it shot up 15.5% in 2012, the small-cap index swelled by more than 8% this year through April 22.

Meanwhile, Independent Value, which accounts for $740 million of the $1 billion in assets Cinnamond’s strategies manage (the remaining $260 million are in separate accounts), has not done much. It’s up 3% on the year and appears unlikely for a performance boost in the short term. Cinnamond has fled from the party by unloading many of his holdings and letting cash build up to a whopping 58% of his portfolio as of March 31.

Given the recent disparity between Cinnamond’s performance and that of the Russell 2000 Value, how is it that he’s activated a soft close and is turning away would-be investors?

He reached his $1 billion limit mostly by way of inflows rather than from performance; Independent Value and his separate accounts netted $660 million worth of inflows in 2011 and $224 million in 2012. It suggests that Cinnamond’s 15-year track record has earned him a good deal of trust among investors.

Cinnamond says that his investment universe— the 300 small caps on his watchlist—has enjoyed a runup and is approaching what he believes is the peak of its performance cycle. A downturn, he believes, is approaching.

His performance over the course of the previous two market cycles gives his investors confidence in his long-term vision, even if it means he’s not trying to squeeze every last cent out of the ongoing small-cap boom. “We focus on adequate returns for the risk we’re assuming,” he says. “So, we don’t play along; we just pull back and wait. Sometimes, you have to underperform to have a lot of success later.”

A Proven Commodity
Cinnamond is pleased with his win rate, which, according to River Road’s documentation, sits at a handsome 84% from Nov. 1, 1998, through Sept. 30, 2012. The presentation materials for potential investors and financial journalists list every stock Cinnamond has purchased since he established his strategy at Intrepid Capital Management 15 years ago, through Independent Value’s January 2011 inception, to the present. Three columns of green print list all the buys that turned into profitable sells. A short list, in red, sits off to the right. Those are the ones that didn’t work out so well.

It makes for an effective visual, putting those 137 victories side by side with the 26 whiffs. Cinnamond could probably do pretty well for himself by simply passing that slide around and letting it do the talking for him. Except he wants to talk about the York Group. And about Gibson Greetings. They’re in the red list.

“We’ll go through periods of significant under performance,” he says. “Value investing can be extremely uncomfortable because you have to buy out of favor. When you do that, you can perform out of favor, and we do. There are periods when we’ll underperform by hundreds of basis points. You have to be willing to look out of touch and lose assets.”

So, losses are going to happen. The key, he says, is avoiding the big loss. He learned that from the York Group (later bought by Matthews International) and from Gibson Greetings (bought by American Greetings). Cinnamond was rocked by both in 1999, early in his time managing assets. He sold York at a 55% loss and was hit with a 64% loss by Gibson.

“To this day, I think I was the only manager to lose money in 1999,” Cinnamond says. “I was down 8% that year. In hindsight, I’m almost proud of that year. It was smart to not play along with the tech bubble. We picked up a lot of small caps that paid off by 2002.”

The lesson: Avoid the big losses by knowing when to back away from a melt-up, and remember that savvy use of cash can go a long way toward normalizing performance. His worst year was the negative 8% showing in 1999, when the Russell 2000 Value lost 1.49%. Other than that, though, when the index was throttled, Cinnamond held up comparatively well. In 2002, the index dropped 11.4%; Cinnamond was up 10%. In 2007 and 2008, the index plunged 9.8% and 28.9%, respectively. Cinnamond was up 9.2% in 2007 and limited his losses to negative 6.1% in 2008.

It’s equally true that his strategy has missed out on the top end of performance spikes in the small-cap universe as he begins to gather cash before the bottom falls out. But he’s bested Russell 2000 Value by more than three percentage points since he started managing money, and he’s done it with less volatility.

“We’ve proven that we won’t let maintaining assets drive our investment strategy,” Cinnamond says. “That happens in our industry too often. I’ve been fighting that my entire career. A lot of it is driven by the goal of being hired by consultants. I’m very passionate about it. It’s so much easier to just look like a benchmark. You’d be rich, but what about the client?”

It’s an approach, Cinnamond says, that has its detractors.

“When things get expensive, I’m not thinking of how to make 20% this year,” he says. “I’m not thinking about some benchmark. I’m thinking, ‘I want to be in things that aren’t crowded,’ because when the cycle turns, everybody else is going to be in the same thing.”

Performance Perspective
Bradley Alford is chief investment officer of Alpha Capital Management, which runs Alpha Defensive Growth ACDEX and Alpha Opportunistic Growth ACOPX, a pair of alternative funds of funds that have invested in Cinnamond’s strategy since he plied it at Intrepid Small Cap Fund. When Cinnamond left Intrepid in 2010, Alpha sold its investments in that fund and waited for him to set up shop elsewhere.

“We believe wholeheartedly that those track records are generated by the portfolio manager and not the firm,” Alford says, pointing out how quickly Cinnamond’s strategy reached its billion-dollar cap. “He raised $700 million overnight. That’s the fastest I’ve ever seen that happen.”

Although Alpha has slightly pared back its investments in Independent Value, Alford said his firm remains a strong believer in Cinnamond’s strategy and supports his conviction.

The approach is fairly simple in terms of how it’s organized. Cinnamond monitors 300 established companies, the average age of which, he says, is about 50 years old. They all have strong balance sheets, sustainable cash flows, and attractive valuations. He’ll look past either operating risk or financial risk, but never both simultaneously.

Independent Value is concentrated—it holds fewer than 30 names—but even the biggest investment, natural-gas firm WPX Energy WPX, accounts for just 4% of the fund’s assets. Precious-metal miner Pan American Silver PAAS, business-services provider Sykes Enterprises SYKE, rent-to-own retailer Aaron’s AAN, and gold producer AuRico Gold AUQ each account for more than 2.5%, as well.

Cinnamond closes the strategy at $1 billion in order to stay nimble enough to traffic successfully in small caps. River Road, which operates the mutual fund, has followed Cinnamond’s recommendation and closed the fund to new investors. According to Aston Asset Management CEO Stuart Bilton, however, it is possible to invest in Independent Value through advisors with clients who have assets in the fund.

Alford said the $1 billion limit is shareholderfriendly. “He could raise billions, and he won’t do it,” Alford says. “You look at these $3 billion and $4 billion small-cap funds, you get into these companies you can’t get out of. He won’t raise more money just to give himself the manager fees.”

Alford was with Cinnamond’s strategies in two previous market cycles (from the late-1990s to 2002 and again from 2003 to 2008) and observed how shrewd the manager is at adding future high performers when the time is right.

“It’s a love-hate relationship; we love (Cinnamond’s approach) on big correction days,” Alford says. “He’s a very difficult manager for me to hold right now. From our point of view, we want a manager to be fully invested and not be tactical. But he’s proven he knows what he’s doing. He’s been right for so long, so we’re confident eventually he’ll be right again.”

Cinnamond says the small caps are, collectively, near their earnings peaks, and that investors continuing to dump money into them are making dangerous projections that those stocks will continue to exceed their historical norms.

“It’s called extrapolation risk, and we try to avoid it,” Cinnamond says. “It’s one of the deadliest investing sins. It’s taking current trends and operating results and interest rates—the environment—and extrapolating them too far into the future, based on the premise that current conditions won’t change. People are paying for peak profits and for peak multiples. In 2007, a lot of stock prices appeared reasonable based on profit levels, but they were at peak profits. Profits don’t stay at the same level.”

Too Short-Term Focused
Cinnamond says the investment community’s increasingly short-term focus and insistence on benchmarking its asset managers have driven ingenuity from the industry. He believes other talented active managers are stymied by investors—both institutional and private— being vastly more sensitive to short-term fluctuations than they were when he was establishing himself. He says that the days when an asset manager had years to establish a comfort level with investors—mirroring the pace of an investment cycle—are over.

“It’s so short-sighted,” he says. “They want you to outperform, but they don’t want you to look different when you do it.”

He says he views it as an asset manager’s fiduciary responsibility to look beyond the usual indexes.

“We want to make money,” he says. “Isn’t that our fiduciary duty? Isn’t that what people pay us to do?”

Michael Brennan is a copy editor with the Morningstar Fund Research Team.
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