VALUE: After Hours (S07 E27): Eric Cinnamond on small cap value, inflation, tariffs, deficits, Mag 7, and AI cap ex
Thursday, August 21, 2025 · Johnny Hopkins
In their latest episode of the VALUE: After Hours Podcast, Tobias Carlisle, Jake Taylor, and Eric Cinnamond discuss:
- Small-Cap Value’s Four-Year Struggle
- The Buyback Effect on Large-Cap Dominance
- AI Hype vs. Reality
- Profit Margins: The Haves and Have Nots
- Consumer Weakness and the Affordability Crisis
- Mirages, Market Psychology, and the AI Boom
- Parallels to the 1999 Dot-Com Bubble
- Current Small-Cap Investing Opportunities
- Tariffs, Inflation, and Premiumization
You can find out more about the VALUE: After Hours Podcast here – VALUE: After Hours Podcast. You can also listen to the podcast on your favorite podcast platforms here:
Transcript
Tobias: I think we’re live. This is Value: After Hours. I am Tobias Carlisle. Joined as always by my cohost, Jake Taylor. Our special guest today is Eric Cinnamond. 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.
Eric: Hey, Toby. Great to see you. Jake, well, I was going to speak with you.
Jake: Yeah.
Tobias: How is small-cap value doing?
[laughter]Eric: Awesome. Incredible.
Jake: Objection leading the way.
[laughter]Eric: There’s no better place to be than active small-cap value. And then, you sprinkle on the absolute return tilt and– Yeah, things couldn’t better.
Tobias: 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 set?
Jake: Let’s not worry about the historical. How does it look going forward?
[laughter]Tobias: The past is the past.
Jake: Yeah.
Eric: Well, what’s interesting though about the past, is the last four years, people don’t realize this, but small-caps have gone nowhere. Four years is a long time. I mean, that’s college, right? They’ve made no money, maybe it’s 0% to 1% depending on the benchmark.
Meantime, the S&P 500 is up since that time 50%. The QQQs are up around 50% or 60%. So, significant underperformance in small-caps. We’ve been able to hang in there and generate small annualized return. I think since inception, we’re up seven, which is around the same as the small-cap benchmarks. But as you know, we really haven’t been invested too aggressively. Very defensive, especially with the cash. On average, we’ve only been about 20%, 25% invested since inception.
So, macro perspective, I guess, or from the top down on performance, it has been great. We’ve kept up, but definitely lag the larger cap, which I don’t know how you can keep up these days. Nvidia, I heard, is 8% the S&P 500 right now. If you have a 5% weight in that stock, you’re actually conservative.
Jake: [laughs] Yeah.
Eric: [laughs]
Jake: Right.
Eric: You might have a little too much tracking area to keep your job with a 5% weight. So, things are a little nutty again. It’s not too dissimilar than 1999. I used to think it wasn’t like 1999. Small-caps were much more inexpensive in 1999. 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 out-flows and you’re getting this consistent drip of small-caps. Occasionally, you have a really good day, like today, where they try to flip the narrative, but without the flows, it’s going to be really hard for small-caps to rebound.
Small-Cap Value’s Four-Year Struggle
Tobias: Why do you think small-caps have struggled so much over the last four years?
Eric: Well, a lot of it’s the flows and a lot of it’s a cycle. And the mega caps, of course, have been the earnings growth have been. The earnings growth for a lot of small-caps have been flat. Since 2021, we had the boom in profits and stock prices. 2022, stocks rolled over and since then it’s been hard to grow earnings for a lot of these companies.
You have a lot of goods companies that boomed during the COVID period because of all the stimulus money, the checks being handed out. All the consumer names are now in recession. Transportation is in recession. Energy is rolling over. There’s a lot of industries now that are in recession. That’s one of our themes is to buy businesses already in recession. We’re not waiting. We really love to buy cyclicals that are experiencing declining earnings, declining revenues and earnings recession.
But to answer your question, I think it often flows earnings growth and buybacks too. I think buybacks is a significantly underrated, understated catalyst of asset inflation, especially– I mean, obviously, in the equity markets where that’s been more towards the large-caps, where you have profit growth, you usually have the ability to– Or, more likely to do buybacks.
The Buyback Effect on Large-Cap Dominance
Buybacks now are four to five times greater than passive flows. Everyone talks about the passive flows, but the buybacks are much larger on a flow perspective. So, I think that’s helped the large-caps as well.
Tobias: Yes, so, the large-caps are doing lots of buybacks but at very elevated valuations and they’ve got the cashflow.
Jake: Isn’t it like Apple’s got a plan to be $100 billion of the $1 trillion that are scheduled or something? It’s an insane number.
Eric: Yeah. The buyback for Apple I think is $100 billion. Their market cap now, I think it’s trying to get– It will be the next $1 trillion to $4 trillion. I think it’s $3 trillion, something. So, on a percentage basis, the buyback, you’re like, “Oh, it’s not all that relative to the flow, but it’s a lot of their, if not all of their cashflow. [laughs] So, Apple’ balance sheet is, and I’m not an expert on Apple, but just by glancing at, it’s really not that strong. Last time I looked, I thought that had negative working capital. I know they have some securities 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’s a lot worse than a lot of the companies we follow. Not small-caps. [Jake chuckles] I mean, you do it in percentage basis. So, I don’t really get the Apple balance sheet. And of course, now, they’ve committed to investing, what was it, $600 billion of capital in AI or chips or investing in the US. I don’t know where that’s going to come from or if they’re going to borrow to do that. So, yeah, Apple’s really interesting. But again, I’m not an expert.
Tobias: You can just say those numbers. You just say, I’m going to invest $500 billion and they just like– [crosstalk]
Jake: Okay.
[laughter]Jake: Yeah.
Eric: Yeah. We were talking earlier about AI. If maybe the number is $500 billion a year investment– I mean, that is just a crazy number. We just throw around these big numbers now, because they’ve gotten so big. I remember back in the tech bubble, we weren’t anywhere close to that kind of investment in the internet and telecom. So, this is a lot of money.
We go through the conference calls like we do last quarter. I don’t think any company we really follow said anything positive about AI, or using it to enhance productivity yet or create revenues. Force is very early. That’s a big CapEx number. [chuckles] 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. That’s one thing I would say, 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 that forced investment or the aggressive investment either infrastructure because of government spending or AI infrastructure.
AI Hype vs. Reality
Tobias: It feels like dot-com 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 it. I understand that the AIs are getting close to their limits of 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 like what happened to the dot-com post 2000 to 2025 was building out all the internet tools.
Eric: Yeah. AI right now, what you could do with it’s obviously a very good search engine, but it also writes very good raps, if you like rap music. [Jake chuckles] So, if you’re a rap content provider, I think your toast. [chuckles] 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 five– [crosstalk]
Jake: I can help you with that one.
Eric: Yeah. Well, Jake it said a drop five, but the rules for this league and I game specifically the age–
Jake: 14U, you need BBCOR.
Eric: You need BBCOR. Drop three. [Tobias laughs] So, I go out and buy the drop five. Well, AI cost me $300. So, there you go. [laughs] So far, AI is not helping me.
Tobias: It does make a lot of mistakes. I think we’ve–
Eric: [laughs] Well, it’s interesting with AI, you’ll use it and you’re like, “Wow, it knows a lot. It’s very interesting.” But then, you ask it about something you know a lot about and you’re like, “Wait a minute, it [unintelligible 00:08:40].” [laughs]
Tobias: It’s trying to find the most likely word that follows 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 definitionally not the mainstream take, it’s going to be a fringe take, it’s terrible. I think it’s generating those fringe ideas.
Eric: I agree. And the content is just like you said, it’s mainstream. It’s not very creative. I actually, recently tried to ask it to write a blog for me using our content on our website. I was just curious. It was almost like a highlight reel of what we had written. It just wasn’t very good. I mean, you spend $500 billion, I hope it improves and I’m sure it will. So, it’ll be interesting to see how that plays out.
But just like the tech bubble 1999, a lot of those companies, same path of the stock price eventually collapse and many went out of business, the ones that were initially benefiting, so we’ll see where this all goes. I’m sure something will come out of it, but how it affects asset prices and the economy too.
Right now, you’ve got AI boom, you have government spending boom, $2 trillion deficits, $6 trillion in spending. You got credit spreads are tight. Asset prices, stocks are at record highs, home prices are at record highs. They never came down. I think it’s really tough in this environment to be in a recession. So, we’ve been very critical evaluations, but we haven’t really said we’re in a recession, because there’s just so much spending, so much stimulus to drive earnings and drive the economy. Even though they’re artificial, they are having an impact.
So, we’re careful to extrapolate this environment. So, I think we’re more we’re normalizing instead of extrapolating which is keeping us out of a lot of these names if you more normalized profit margins.
Profit Margins: The Haves and Have Nots
Tobias: That’s one thing I did notice when I went through the Yardeni site. They track the profit margins for large, mid and small. I published this on Twitter. The large is at like– I forget now, but it’s 13 plus. It could be 15, something crazy like that against the long run average of six.
Eric: Yeah.
Tobias: Mid is well down, but it’s still higher than it was pre-COVID. And so, small, which I found really shocking. The margins there are still higher than they were pre-COVID. 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 know if it’s– [crosstalk]
Jake: I wouldn’t have thought that. I would have thought Russell 2000 margins look like crap with just based on the narrative.
Eric: Yeah. We’re finding a lot of have and have nots. There’re some businesses that are generating incredible margins. Those are the ones that have benefited from asset inflation and inflation, in general, where they’ve been able to pass on pricing. You look at something like a Costco. If you have 30% inflation over five years and you can pass all that on which they have, their margins have been maintained. I mean, they love that. They love inflation.
Maintaining your gross profits and gross margins are two different things. [chuckles] They maintain 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 from the bottom up on margins. There’s certainly things that are skewing that number one way or the other.
Jake: Eric, wouldn’t you say though that’s like a short-term phenomena, where your fixed costs were paid for with higher-
Eric: Yes.
Jake: -more appreciative dollars.
Eric: Absolutely.
Jake: But then, when it comes time to start putting a new roof on a Costco or 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?
Eric: That’s a great point. I don’t think that gets discussed enough. But frankly, when do fundamentals like this get discussed?
[laughter]Jake: Yeah.
Eric: This is saying- [crosstalk]
Jake: One podcast left.
Eric: -CapEx below average because of inflation. I mean, that’s a great point. So, right. So, margins using historical depreciation are likely overstated. A great example are, a new truck now for the trucking companies, probably 20%, 30% higher, especially with the new standards on fuel efficiency. So, there’s a lot of that.
So, there’s a lot of deferral going on, because they know and trucking is not a good example. They are deferring purchases of new trucks, a lot of the public companies are. That’s also because of trucking’s in recession. 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 across the board. That’s a lot of PPE, property, plant, equipment.
Jake: Now, that’s the next investors problem two years from now.
Eric: Right. [crosstalk]
Tobias: Next CEOs problem.
Eric: Two or three years down the road. That’s three generations of investors. [laughs]
Jake: Yeah. [laughs]
Consumer Weakness and the Affordability Crisis
Tobias: What do you think the earnings of smalls? Do you think there was consumption pulled forward through COVID and through all the stimmy that’s come afterwards? Because I’ve noticed the same thing that there’s a very definite peak around 2022 in terms of margins, in terms of earnings, in terms of stock prices, and then it’s run backwards since then today.
Eric: Yeah. I agree. So, an example would be Carter’s, right? They’re the market leader in children apparel, baby apparel. They were crushing it after COVID. Everyone was getting their stimulus checks and they didn’t really care if they were paying $10 or $12 for a pair of pajamas. So, they were able to raise prices. And not only did they have some volume growth, they had the pricing power and all of a sudden, they were making considerably more margin, and cashflow and profits.
They start buying back stock in the 80s, $100 stock, it’s just booming. They’re making &7 to $8 dollars a share in earnings. And then, the COVID stimulus went away, the inflation hit, now young families are having to decide between paying rent, and buying new pajamas and the decisions a lot more difficult.
Jake: Student loans, they got to pay now where they weren’t before.
Eric: Yeah. So, now, you’re like, “All right, I’m going to pay rent and now no pajamas for Timmy.” [Jake chuckles] And so, now, their earnings are probably $2 or $3 a share, the stocks at $25. A lot of companies did that, especially on the consumer side, they extrapolated that boom. Transportation did it too. And now, some have gone bankrupt. Most are in recession. It’s an area of the economy that I think illustrates what’s going on with the consumer. The difficulty they’re having making ends meet and especially on discretionary spending.
But even food. I mean, even Staples now are getting hit by, 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%, power, lower purchasing power or cut in purchasing power and affordability that’s the issue.” They’re not addressing affordability. I mean, the inflation rates at 3.1% now on the core, they reported today. We’re actually talking about cutting interest rates when the biggest problem, 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. 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. I don’t get it. It’s like, “What are you doing?” The populace is going to vote everyone out. They’re going to give– I won’t say that, all right, I’m going to back up here, But they’re going to vote them out, right? They’re going to bring someone in that’s going to redistribute the wealth. And you can’t blame them. I said no ranch, Toby. I’m sorry.
Tobias: No, no. We won’t say ranch.
Eric: [laughs]
Jake: Other than that, how was the play, Mrs. Lincoln?
Eric: 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. This is going to be one of the best cycles ever for patient investors and disciplined value investors, which we talked about earlier. That’s probably about 14 left. [Jake laughs] It’s going to be great.
So, 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 the aftermath that will help us and our clients, hopefully, make some money.
Tobias: I think Powell’s done a reasonable job. I think that the problem was that the free lunatics who preceded him who have created the–
Eric: [laughs]
Tobias: I think Bernanke certainly was probably the worst of the lot, but then Yellen’s just continued everything that Bernanke did.
Powell’s been the first one to raise rates, even though he’s probably done it too slowly. But I understand that people use the two-year as a reasonable proxy for whether the Fed funds rate should sit. Powell, I think, has tracked it more closely than anybody else, even though he’s a little bit below through the entirety of the 2020 recovery. What do you think?
Eric: Well, in 2018, I thought the same thing. He started to raise rates and it looked like he was going to try to normalize the balance sheet and then stocks fell 20%. He flipped so fast.
Tobias: Yeah.
Eric: Stopped raising rates, started to QE again. They called it something else. And then, during COVID, every company were following practically was clearly, clearly forecasting higher prices. Their costs were going up. We wrote about it a year before. It just was so obvious. We couldn’t believe the Fed was still at zero and they were still printing money. It was crazy. And then, [crosstalk] year later.
Jake: What are all these PhD economists doing there?
Eric: Yeah, 9% inflation. And then, everyone says what’s going to bring down this market cycle? I said, “Well, I thought 9% would have done it, [laughs] inflation,” but it didn’t. So, I think he started out with good intentions. I think all the central bankers probably have good intentions, but no one wants– It’s not his fault that he’s in this situation. I agree. I think Bernanke was the godfather.
Greenspan, [chuckles] he was horrible too, but but at least he never printed money. Bernanke printed money thinking that was actually a solution to our problems, which every central banker that studied history should know that this is the last thing you want touch.
Tobias: Well, he studied history. He was an expert in The Great Depression.
Eric: Yeah. Well, people talk about housing now. I would, because we sold our house in the bubble and I would sell it again if there wasn’t money printing. But it’s such a big risk to sell and rent right now because of the fear or the real possibility of them resorting to QE, which they might even. They’re probably going to have to do at some point.
So, anyways, I was a fan of Powell also, first. I think he tried to do the right thing and then when he saw like, “Whoa, I could see how this could all unravel pretty quickly with me trying to do the right thing,” he backed off. And now, he’s just trying to make it to the finish line. I think he’s going to make it.
But just like Greenspan. Greenspan made to the finish line, still got blamed for the housing bubble. I think, Powell, who printed more money than any US central banker in history will also get the blame when the cycle ends. Partial.
Tobias: On an absolute base. Of a higher base.
Eric: Yes. Yes. But I agree with you on Bernanke. And Yellen, 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. Credit to her.
So, yeah, it’s been a fascinating central bank kick the can. It’s just like an average banker. When you have bad loans, how do you not let bad loans go bad? You write more bad loans. [laughs] So, it creates a perception that as a percentage that the loans aren’t so bad, so they’re just going to keep it going until something snaps.
Tobias: Do you know the thing that amazes me is we’ve still got a 10:3 inversion. It started in 2022. 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 18 months or something like that. So, we’re now three or four years into this inversion.
Jake: Is that a record?
Tobias: It’s a record in the data that they have on the Fed website. But I’ve heard from– I’m forgetting the firm name. Adam Butler and co said that– [crosstalk]
Jake: Oh. Gestalt.
Tobias: Yeah, Gestalt has a longer history that shows that there have been very long inversions in the past, since 1900 basically.
Eric: Yeah. The long end is interesting. I think the 10-year now is a little over four and the 20 year is 4.85. So, you could still get a decent absolute return yield if you’ll take the maturity risk. It seems 5% for the Fed is a scary number. Every time we get close to exceeding that on the long end, someone seems to be on top of that making sure we don’t break out there. So, that’s a hard number or interest rate for us to afford. I think the government’s very aware of that.
Tobias: It’s been up every single year since 2020. 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 2024 to 2025. The front end has moved all over the place, but 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 that.
Eric: What was the 10 year when the Fed cut last year? It was three something. I’m not positive. 50 bips to 75 bips. I don’t follow the tenure too closely but I know it’s up quite a bit. So, I think that may have caught them off guard where, like, “Whoa, we lost control of the long end here.”
Jake: Well, certainly, mortgage rates haven’t followed the Pied Piper’s tune.
Eric: And what happens if mortgage rates do fall? What if they do cut rates, let’s say to zero and mortgage rates go back to 3% to 4%? You should see a million-dollar home around here. It’s like, “So, what?”
Jake: Yeah.
Eric: And now, you’re going to drop rates and spur the housing market again. That goes back to affordability. I don’t think you’re doing anyone any favors except people with paper assets.
Tobias: 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 shuffling off this mortal coil over the next 20 years. Well, there has to be buyers on the other side. It’s not going to be BlackRock. It has to be some young family somewhere.
Eric: Right. It should be– [crosstalk]
Tobias: Thank God for BlackRock keeping those young families out.
Eric: Yeah. Well, going back to Carter’s, one of the headwinds they’ve had is the birth rate. The younger generations can’t afford to have kids. [crosstalk] It’s sad when you think about it. You want to talk about the consequences of easy money, I think one of them is clearly there’s less babies. So, that’s not cool. [laughs] So, yeah, that’s going to hurt a lot of things going forward. Population growth is going to decline. Well, plenty of paper money, but fewer people to make goods and services.
Jake: [crosstalk] Well, surely, if you can print wealth, you can print babies.
Eric: You would think. Well, AI might fix that somehow. [laughs] They might not be humans.
Jake: Sure.
Current Small-Cap Investing Opportunities
Tobias: What’s interesting in small-cap land in terms of industries? What do you think about energy?
Eric: We bought our first energy stock last quarter, Chord Energy. It’s an E&P out in the Bakken. And so, we valued it about $139. We’re trying to value the cost of the reserves in the ground, which we believe is about $15 a barrel. Has over 5% dividend.
One of the things I like about energy is how they’ve been so disciplined with cashflow. I thought at first, because most of the time, I’ve been in the industry, since the early 1990s, they all just drill, drill, drill, regardless they got paid on production growth. But over the past 10 years, they’ve done a really good job.
When oil prices got down in the 50s, a lot of the E&Ps started to sell near replacement costs and reserves. So, that got it very interesting. We’re able to pick one up there. We like energy, not all of them, but we like certain ones, especially the ones with better balance sheets. Some of them, because they’ve been paying out dividends and buying back stock, don’t have the best balance sheet. So, we’re really careful there.
We like transportation, we like the trucking companies. We own Heartland Express. That’s old-school value stock that’s gotten absolutely destroyed. So, we like companies that are already in recession. That’s a great example with the trucking companies. This is the third year that they’ve been in recession, the business and the industry. We’re avoiding companies that are doing really well.
[laughter]Eric: We’re the opposite–
Tobias: Me too. But that’s how [crosstalk] too.
Eric: And their stocks too. So, it’s been a lot. We talked about this earlier. It’s been a lot like 1999, where we’re buying really out-of-favor names that the stocks are in decline, the flows are horrible, the earnings are declining, but that’s actually when you want to buy cyclicals, when things are bad and getting worse, because the stocks, when you get them cheap– You’re not going to get an energy company cheap when oil’s at $100 a barrel. You get it cheap when it’s at $50. So, painful operating results right now for all these companies, but some are stabilizing.
We also like companies right now that are intentionally shrinking. Heartland qualifies for that too. They’re actually shrinking their fleet. They’re spending 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 cashflow by breaking even. And this is on a $600 million market cap. So, they’re generating plenty of cashflow. They actually bought back a million shares last quarter.
We own Monro. They do auto repair shops. That’s another one that’s shrinking. It closed 145 stores. They have over 6% dividend. They’ve generated a ton of cash even in this period. But the consumer is cutting back on maintenance on cars. So, just be careful out there. You see a car, you see an older car, it might not have brakes. [laughs] It might have bald tires. So, beware. But people are deferring those. We can only defer those for so long. But yeah, business has been poor for them, but again, that’s a consumer discretionary. That’s not really discretionary, but that’s when you want to own those too.
But their comps have turned positive recently, so we’re hopeful there. So, companies in recession that are stabilizing, even better. Companies in recession stabilizing, they have good balance sheets, even better. So, that’s what we’re focused on right now.
Tobias: Energy versus the market is as cheap as it’s been. I mean, two times cheaper were 2020 and 2000 [crosstalk].
Eric: In this environment, wouldn’t you want to own something that’s tangible at a discount to replacement costs? I find that attractive. We own a farmland REIT too, Farmland Partners. So, if I can buy acreage of farmland at a discount, or reserves in the ground at a discount or even some receivables. We own Kelly Services, the temp agency. The receivables are at a discount to market cap. Yeah, that’s great. So, we love asset-heavy companies right now too that are selling a discount to the tangible book.
Tobias: Let me give a quick shoutout, and then JT, you want to do some veggies?
Jake: Yes, sir.
Tobias: Santo Domingo. What’s up, Danny? Valparaiso. What’s up, Mac? Tallahassee. Dead Cat Gully. Andhra Pradesh. Jupiter, Florida. Cincinnati. Boise. Budgiesmuggla. Les Whynin in Budgiesmuggla, Australia. Fairfax, Randle. Gerards Cross. Mean streets of Gerards Cross (emphasis on mean streets) Brandon. Surbiton. Madeira Island, Portugal. Toronto. [laughs] And John Battle gave us a $50 tip.
Jake: What?
Tobias: Thanks, brother. Appreciate. Sponsoring the veggies. [Eric [laughs] Today’s veggie sponsor is John Battle. That’s a brand-new thing we’re doing just today.
Jake: Yeah, we just thought of it. Better give him a rebate.
Eric: [laughs]
Tobias: Corvallis, Oregon. Last one. And then, we’ll come back to the question. JT, floor is yours.
Mirages, Market Psychology, and the AI Boom
Jake: Yeah. You, guys, did an amazing job. http://cut with the first part of our discussion as you will see. Totally unbeknownst. 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 ho.” 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? 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 mirages, superior and inferior. You’ve no doubt seen the desert mirage, which is that shimmering pool of water on a hot road. That’s the inferior mirage. The superior mirage is different. Here’s how the physics of this works.
Light doesn’t always travel in a straight line, 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 in a property that’s called refraction. 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. Think about the temperature up at the mountaintop compared to down in the valley below.
In these normal conditions, the cold layer is above the warmth, 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 flips that layering. The cold, dense air is then near the surface, and then on top of that is the warmer, lighter air. 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, because it’s very cold air off of the snow. 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 actually can see things like over on the other side of the horizon. So, mountains that are hundreds of miles away appear to be rising into the sky in front of you. And phantom ships may be sailing beyond what you could see, like there they are. And even coastlines seem to be hovering in midair.
The images are actually aren’t fuzzy. Sometimes they’re often sharper than real life, because the air acts like a lens and zooms in a little bit. This is most dangerous part is that it’s incredibly believable that this is actually there. Historians speculate that the Vikings ventured to North America sometime around 1000 AD after spotting a superior mirage of the mountains of Baffin-island from the coast of Greenland. So, they’re almost peeking onto the other side of the Earth because of this. It looked to them like the land was much closer than it actually was. So, they were like, “Okay, let’s set off and go explore that.”
So, of course, the cousin in the desert of the mirage is 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 pools shimmering in 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, the cold air is the hard, measurable progress. These Frontier LLMs are scoring higher than 90% of humans on specific tests. Automated coding assistance helping save weeks of development time. These AI agents that are boosting productivity and narrow domains. 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 above that, the trillion-dollar TAM slides, the breathless coverage about AI replacing entire industries next quarter, stock market pricing and decades of compounding before any cashflows arrive. Half the workforce is being laid off by Christmas. That speculative heat refracts our expectations, bending the arc of reality, so that 20-year payoff looks like it’s two years away as an inevitable thing.
So, these mirages are then precise enough to tempt people into misallocating their resources. So, they set sail, they burn precious time and fuel. When the illusion fades, the true distance finally reels itself as being greater than ever before. So, who knows? Maybe the real breakthroughs might be a decade away. But the mirage convinces us to act and spend as if the miracle is right around the next bend.
And so, just like those arctic sailors, we might get there eventually. The land is real, but the timetable probably isn’t. So, that’s why when I recently was reading a headline that Meta is tapping Pimco and Blue Owl for, I think it was $29 billion of debt for datacenter projects, that’s a little concerning. Like, you tapped your balance sheet, you took a bunch of cash out, now you’re going to lever it up to keep going, well, that implies then that there’s a time period that you need to reach shore by, and that can be difficult.
Parallels to the 1999 Dot-Com Bubble
So, I don’t know, Eric, are there any signs that you see today that rhyme with the dot-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?
Eric: Yeah, of course. It’s feeling more and more like 1999. I remember 1999 still very well. I was a young manager. It just felt the same where you just felt like an idiot, [chuckles] you’re missing out, and it was very hard. We were talking earlier about that’s when I went and enrolled to a graduate school, because I thought I didn’t know what I was doing and my career was over. But of course, it all–
This was what I don’t think people really appreciate. The internet bubble popped without warning. 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 chasing a speculative bubble, they think they won’t get hurt, because they’ll be smart enough to get out.
But I remember one day just coming into work, it was March of 2000 and it just crashed. These internet stocks crashed. So, I think there’s a lot of similarities right now. But investor complacency is probably the biggest and the feeling again of when you’re not participating. I was a lot younger then, so I thought I was a lot smarter than.
Jake: Yeah. [laughs]
Eric: So, I think it was harder for me in the 1999 bubble, because I went from feeling so smart to so stupid. That transition was really hard for me personally. But this time around, I mean, it still is horrible. I hate not participating. We want to be fully invested and we really do. We want to be making money. We would love to be making 20% a year on the QQQs and compounding that.
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 going to make tomorrow? I don’t know. I can’t wait. [laughs] That’s going to be so awesome. So, that feeling– [crosstalk]
Tobias: They make great businesses too.
Jake: Yeah.
Tobias: They’re such great businesses. It’s so easy to be invested in.
Eric: Yeah. And take that feeling, Toby. And then, the inverse of that is what we’re experiencing. [laughs]
Tobias: And they’re terrible businesses. The businesses we’re invested in deserve everything they get.
Eric: But here’s the bright side, is when it ends and it will, the feeling of being an idiot and then transitioning to feeling that vindication feeling. We don’t really care about relative performance. But when you outperform by thousands of basis points, it’s pretty cool. Yeah.
So, the other side of this is amazing. But making it all in one piece and maybe with a business, maybe not, [laughs] and maybe with some clients, maybe not, it can be wonderful. But I think at this point in the cycle, there’s just fewer and fewer professional managers willing to do it.
One thing I would note about 1999 too, it’s very important. A lot of value managers portfolios did their own transition to try to participate somehow someway, and they did it by buying growth stocks that maybe were they tried to classify as value. They tried to still hold a value category, but still cheap on the side– Not cheap, probably a wrong word, but given a little bit on principle to participate. You can understand that to try to keep your job and keep assets.
So. you can still be value but not really be valued. So, you’d 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, especially in the small-cap side, it might be a red flag. It might not be. It might be an incredible stock selection, but a lot of the genuine small-cap values we believe have horrible charts right now. When we’re looking for new stocks and we see a horrible five-year chart, we’re like, “All right, that looks awesome. [Jake laughs] That’s what we’re looking for.”
Jake: Look at this [crosstalk]
Eric: Yeah. Oh, give me an ugly five year right now. But a good, a really strong performing fund right now will have some really pretty five-year charts. So, I think you want to be careful of those, do some research, deep digging there and make sure that there wasn’t a shift in philosophy or process and strategy.
Jake: Eric, if you’re an allocator right now, 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 long but–
Eric: Yeah. Even a 15-year, Jake, now 10 and 15– 5, 10, 15, all tell you to allocate to the S&P 500. And how are models made, how are capital allocations model made by looking backwards. So, everyone’s like, “All small-caps are going to come back. They’re so much cheaper.” I don’t know if I would agree with that, because if you look backwards, all the numbers tell you to buy large-caps. 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 numbers will tell you to be in large-cap. And until that changes–
This is another thing that was similar to the late 1990s, 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 2000-2002, small-cap value stocks had very, very good gains. But the large-caps in the NASDAQ was down, what, like 80% something crazy. So, you were able to make money in a severe bear market by doing exactly that kind of buying what’s out of favor before the bubble pops.
So, you want to be very careful right now, because I think most allocations would suggest to go with what’s done well. It hasn’t done just well for a few years. So, they can justify it easily by saying it’s been 10, 15 years. That’s a hard number to dispute versus a two year, three- or 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 bear market over that period. You want to be really careful now. It sounds weird, but you want to be careful not to use long periods of time to make investment decisions.
Jake: Eric, when the world is such where buying every dip has worked, the belief in the superpowers of central bankers and governments to do whatever it takes to keep corrections from happening. What does it take an 80% down to disabuse people of this Pavlovian dip buying that they’ve been so wired to do over the last 15 years?
Eric: I think so. 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 buy the dip and have been rewarded. This time is different article. Another one. [laughs] They haven’t had enough of those. So, I do think, as I learned in the 1990s, I 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 they can make money so easily.
Really, if we wanted to make money even in our fund right now, I think we could do it and I think we can make a lot. But I also think we would be setting ourselves up for losing a lot of money. I’m telling you you will not be the person that gets out first. If you do, you’ll be very exceptional timer. We’re not market timers. But the risk right now, especially in the large-cap side– I’m not promoting small-caps. We don’t think small-caps are particularly cheap, 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–
Back in the 1990s too, you had Gillette, Coke, 30, 50 times earnings, those got destroyed. People, they think because they’re in high quality, they’re protected. That’s not true. Costco at 50 times earnings could easily lose half of its value easily. So, people need to be aware of that as well, that quality is not a perfect way to control risk. Valuation is much more important.
Tobias: I got a good stat 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.
Eric: Go, small-cap.
Jake: [laughs]
Tobias: I was amazed that they had that much to lose.
Jake: Yeah. That’s just all wiped out. [laughs]
Eric: Well, what is the Russell 2000 ETF? It’s like, $10 billion maybe. I really don’t know.
Tobias: I had a look at IWN. IWN?
Jake: Yeah.
Eric: NRM. There’s a value in– [crosstalk]
Tobias: It’s $4.4 billion.
Eric: Oh, it’s embarrassing. [laughs] The Vanguard, or whatever it is.
Tobias: V-I-O-O.
Eric: What is that? It’s several hundred billion, I think. In the big active funds now, you look at let’s– I don’t want to get sued here, so I got to be careful. The Contra Fund. There’s a fund out there called the Contra Fund.
Jake: [laughs] Who knows it does it. Yeah.
Eric: What does contra imply to you? Maybe contrarian? Maybe?
Tobias: Well, on Twitter, contra is someone who you trade against. Yeah, it does sound contrarian. That’s right.
Eric: 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’s like the Mag-7 fund. So, even the active managers, I think, have figured out, if I don’t own the big weights of these names, we’re going to risk underperforming and risk losing assets. The fund is not incredible, and so is the assets under management.
So, I think if you overweight some of these names doing really well, like we said before, 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 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 going even further than that. Those flows are huge, Toby. I remember back in the 1990s when we had year 2000, there was $50 billion inflows and everyone thought that was nuts. [laughs]
Jake: Yeah.
Eric: Now, we’re talking hundreds of billions going into these ETFs and passive funds.
Tobias: There are a lot of companies that have stumbled over the last– Even in large-cap land. I think it’s interesting that it is so concentrated into a handful of names that are performing. I don’t know if it’s 10, but it’s certainly in the top 100. And then, the 490 or the 400, however you want to break it up, they really haven’t done very much. They’ve been basically also flat since 2022. It’s really only a handful of names that have been a beneficiary of that CapEx AI spending-
Eric: Yes, exactly.
Tobias: -have done well through this period. As we were talking about it, 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. I equate it to a 1999 fiber-optic cable build out. That’s not an original thought, but it’s a common 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 three or four years before you get another– Are we going to be spending at this rate all the time? Like, is that just what we’re doing now?
Eric: Yeah. How is that sustainable? I always joke about the tech bubble. At least, we’ve got the internet infrastructure for that. And 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.”
[laughter]Jake: Yeah. It does feel like there’s a obsolescence. Let’s rewind even further back. Railroads. The huge CapEx boom, I think it was something like 6% of GDP was being spent on CapEx during the railroad boom. Well, some of those rails obviously they’ve been replaced, but the right of ways are the same as they were 150 years ago, right?
Eric: That’s right. [crosstalk] in CapEx
Jake: You amortize that cost well. But yeah, chipset, let’s be generous and say five to seven years even, which I think is what they’re doing.
Eric: But the ones they’re putting in now will probably be obsolete in 18 months.
Jake: Yeah, maybe.
Tobias: It’s great for Nvidia. I don’t know if the customers can keep up with them.
Jake: Well, and in fairness, my understanding is that those chips they then sell on to the inference side where you don’t need quite as much horsepower apparently. So, it’s not like a total like-
Tobias: Response to China.
Jake: -you [crosstalk] to zero– Well, yeah, I don’t know. So, they’re not like zeros, but yeah, the training chips have to be quite the most powerful apparently. So, those are the ones you got to replace every three years.
Tobias: Are we getting–
Eric: This is why we do avoid a lot of technology stocks. Not because they can’t do extremely well, but because they’re just hard to value. We’re talking about this right now and none of us can really quantify what cashflow are going to be in year five, let alone year one or two. So, it’s just so hard to value. You’re not buying a perpetual bond. You don’t really know what you’re buying. It’s just a tremendous amount of investment with uncertain returns, and that’s more speculation. It could work great. But for us, if you’re just discounting a long-term bond investor, those are really hard to plug in a model.
Tobias: Yeah, you want some steadiness. It seems like energy’s not going away anytime soon. I think energy is a reasonable, but I also saw healthcare is underperforming the S&P 500 by the most since 2000.
Eric: We just bought our first healthcare device company maybe in a decade. Since our inception. I know. But yeah, you’re right, those have been under pressure. So, that’s interesting you bring that up. We’ve noticed that as well.
Tariffs, Inflation, and Premiumization
One thing I want to talk about which we have and is tariffs. We had the CPI number today come in. I think 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 haven’t reported a lot of impact from tariffs at this point, but it’s coming. I just want to be aware of this.
Jake: Well, we should sell a little context to Eric that you do a ton of bottom up reviewing of, I think hundreds of earnings calls that then give you a bottom-up economist viewpoint of the economy.
Eric: Yes.
Jake: Sorry, go ahead.
Eric: Exactly. Exactly. Thank you. So, we’ll get a feel for what’s going on with the companies. I remember in 2021, we were seeing inflation coming straight on. It was very obvious to us. And this is another one of those moments where we see it again, there’s going to be a lag, but it’s coming.
There’s three things’ companies are doing. One, they’re raising prices. 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. They’re going to use prices, and someone else is going to absorb it 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 I mean they will go up on goods for sure, we believe. So, just keep a look. Even though we haven’t really seen it yet, it’s in the pipeline. Companies, when this all started happening in April, they 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, and this could affect jobs as well later this year, early next year as– Again, they’re going to cut costs to try to improve productivity.
Another thing I like too is a lot of them are going to re-engineer their products. So, they used to call it lightweighting, get less and then the whole shrinkflation thing came out and people made fun of it on the internet. And so, now, they no longer call it lightweighting. They call it re-engineering [Jake laughs] which sounds a lot better. “Hey, I’m not getting ripped off. The re-engineering, that’s going to make it better.”
Jake: We re-engineered this bag of chips to have eight chips in it.
Eric: Exactly. [laughs] So, we follow an apparel company. They’re re-engineering shirts, they have less cotton and they spin it, “Oh, it’s more breathable now.” [laughs] At some point, we’re all going to be naked because of all re-engineering. So, that’s another thing to watch for. You’ll see changes in packaging, and product offerings and how they were made. So, yeah, it’s coming. So, there’s no free lunch. Sorry.
Jake: The thing I don’t understand that seems like– If you just think about like you ask yourself and then what one time on this, okay, we’ve got huge margins, known cost pressures coming from tariffs, just even having to just write the check to the government for to get something inside 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 going to eat my margin that I had. I’m going to pay this and like I’m going to pass the savings on to the consumer,” which at some point, that’s what technology has meant like we’ll have more from doing with less input. At some point, where is the game theory of the competition of between businesses to lower or not raise their prices commensurate with the tariff expense?
Eric: Well, especially with small-caps, a lot of these companies are already under margin pressure with rising costs. We talked about trucking earlier. It’s not just demand but they have a lot of their costs, the labor especially and the equipment costs replace equipment, that’s going up. Insurance is going up. So, you have a double whammy right now. The costs are rising. So, now, you feel the tariffs on that too, it’s really going to be hard for them to eat it right now just the way things are going for–
Toby, you talked about this earlier with the S&P500. The 400 or less are actually growing [chuckles] very, very well right now. So, it’s just a hard time to ask a business to eat it, but in aggregate you’re right. The profit margins you would think would somehow come down and but that’s being skewed by the mega caps.
One thing real quick on inflation I want to discuss too, is a theme we’re seeing too companies and that is a premiumization where they are selling more towards those that have benefited from asset inflation. I think that’s really something that– 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. They are more lately been more impactful in setting prices than the lower end.
So, you have two economies, the high end that’s willing to pay anything and the lower end where they’re buying less trading down. There’re two things going on. But as the wealthy get wealthier, they’ve been more willing to pay any price really for–
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 were this little bowl and it was $15. And I was like, “Are you serious? How much is mac and cheese?” She said, “$7.” I go to Publix and get a whole box for $2.
Jake: There goes our Panera sponsorship.
[laughter]Eric: Yeah. But then, I was thinking if I own the QQQs and Mag 7, you know that $7 mac and cheese, [laughs] whatever.
Jake: Yeah, it’s nothing.
Eric: So, they’re setting the prices more towards the person that is flush with asset inflation versus the small-cap value manager. So, I do think that’s really interesting, the price setting right now that’s going on. You saw it with Delta, right? Delta’s premium seating last quarter was up 5%. Non-premium was down 5%. I think that’s the perfect summary of the economy right now and the perfect summary of what we’re seeing with prices.
So, there’ll be some discounting on the low end maybe. But companies have figured out they’re better off doing less than making more. It’s a theme they learned during COVID, “You don’t have to be at full capacity to make money. You can do less, charge people more, make more. It’s a lot easier. “
Tobias: Hey, 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?
Eric: palmvalleycapital.com is our website. So, if you’re interested, stop by. And really appreciate you having me. I always enjoy our conversation, Toby and Jake. So, until next time, thank you.
Jake: Sign up for Eric’s blog posts. I read every single one of them.
Eric: Thank you, Jake. We appreciate that.
Tobias: JT, any final words?
Eric: We got a great quarterly letter too. Jamie writes that, so I always like to plug that. That’s my favorite quarterly letter out there.
Tobias: Q2? Q3?
Eirc: Q2. Check it out.
Tobias: All right, folks.
Jake: No words of wisdom. I used all my wisdom for the day.
[laughter]Eric: [crosstalk]
Tobias: All right. We’ll see you next week, same bat time.
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