Living the Minivan Dream

I apologize for not posting lately. Our kids are in full throttle school and activity mode, which has limited my time to post. I should be back to my old schedule in June once the kids are out of school and their baseball and softball seasons end (unemployment has really helped my kids’ swings!). Until then, I plan to spend most of my work-related time keeping up with my 300 name possible buy list. My backlog of topics to discuss is growing and I’m looking forward to posting more soon.

Today I wanted to briefly write about earnings season. Although it’s very early, results appear to be coming in as I expected. I don’t believe this earnings season will be a catalyst for the bulls or bears. In my opinion, it appears to be more of the same — similar to the past couple of quarters. As I touched on in a previous post, after several consecutive quarterly declines in 2005-2006, the current profit cycle has stabilized. In my opinion, the profit cycle was revived after the drag from the energy credit bust and strong dollar ran its course. Relentless asset inflation – resulting from reassurances from central bankers that global QE will be forever a part of our lives – most likely played a role as well.

While I’m not expecting major changes in operating results this quarter, this doesn’t mean I believe it’s safe to invest in overvalued equities. Price, of course, is the main determinant of future returns and at today’s prices, expected future returns remain well below my absolute return hurdle rates. Therefore, I continue to wait and watch and then wait some more. It’s a very boring part of my absolute return investment process, but essential.

Although earnings shouldn’t be too surprising in aggregate, I continue to expect dispersions between industries. Energy, industrials, and other cyclicals should continue to see some signs of improvement (1-2 more quarters of easy comparisons). Meanwhile, I’m expecting operating results of consumer companies (outside of those closely tied to asset inflation) to remain uninspiring. A good example is Foot Locker (FL). Yesterday the company announced its first quarter earnings will be equal to slightly below last year’s earnings. Management blamed the delay in tax refunds. Instead of declining, Foot Locker’s stock actually increased sharply, as management stated its sales rebounded from a weak February (they also acknowledged the rebound did not fully offset the slow start to the quarter). Regardless of the actual impact tax refunds had on the purchase of sneakers (???), based on the sharp rise in Foot Locker’s stock, the market is apparently in a very forgiving mood. I suppose it is a refreshing change from blaming the weather!

As I’ve stated in past posts, I consider most retailers to be cyclical businesses. And some, such as Foot Locker, can be very cyclical. Below is a ten-year chart of Foot Locker’s operating margins. I actually owned Foot Locker in the past. Can you guess when? If you guessed when operating margins were 1-3%, you’d be correct. At that time (during the last recession), I did not believe depressed operating margins would stay depressed indefinitely. Similarly, I’m currently not assuming Foot Locker’s 13% operating margins are perpetual. In fact, when a mature retailer in a competitive market generates such high margins, the first thing that comes to my mind is their customers are paying too much. Instead of asking how management will expand margins further, as an investor, I’d question how a mall-based retailer can sustain mid-teens margins long-term.

As is the case with most cyclical businesses, I believe normalizing profit margins for consumer discretionary businesses is very important and provides investors with a more accurate and stable valuation calculation. In my opinion, investors currently finding comfort in “only” paying 15x earnings for Foot Locker should consider performing a full-cycle scenario and margin analysis. Assuming a full-cycle operating margin of 7%, investors are actually paying closer to 30x normalized earnings for a cyclical retailer, not 15x.

Foot Locker investors aren’t the only ones incurring significant extrapolation risk these days. Many operating businesses have similar profit margin charts this cycle. In my opinion, one of the many aggressive assumptions investors are making this cycle is that record profits and margins will remain elevated indefinitely. I’ve refused to make the same assumption. In fact, my unwillingness to extrapolate current profit margins has contributed to my decision to go all-in on patience. I continue to believe in the business cycle and the factors that have historically influenced profit margins have not been abolished.

Out of curiosity, I pulled up Foot Locker’s “Risk Factors” listed in its 10-K near the last profit cycle peak (2007) and compared it to the list in its current 10-K (2017). According to Foot Locker, the number of risks to its business has actually increased from 9 near the peak of its last profit cycle to 28 currently. In other words, the risks to future cash flows (or at least the disclosed risk) has increased, not decreased as its equity valuation suggests. See below. Have a great weekend!

2007 Foot Locker Risk Factors (P/S Valuation: 0.6x sales)

  1. The industry in which we operate is dependent upon fashion trends, customer preferences and other fashion-related factors.
  2. The businesses in which we operate are highly competitive.
  3. We depend on mall traffic and our ability to identify suitable store locations.
  4. The effects of natural disasters, terrorism, acts of war and retail industry conditions may adversely affect our business.
  5. A change in the relationship with any of our key vendors or the unavailability of our key products at competitive prices could affect our financial health.
  6. We may experience fluctuations in and cyclicality of our comparable store sales results.
  7. Our operations may be adversely affected by economic or political conditions in other countries.
  8. Complications in our distribution centers and other factors affecting the distribution of merchandise may affect our business.
  9. A major failure of our information systems could harm our business.

2017 Foot Locker Risk Factors (P/S Valuation: 1.3x sales)

  1. Our inability to implement our long-range strategic plan may adversely affect our future results.
  2. The retail athletic footwear and apparel business is highly competitive.
  3. The industry in which we operate is dependent upon fashion trends, customer preferences, product innovations, and other fashion-related factors.
  4. If we do not successfully manage our inventory levels, our operating results will be adversely affected.
  5. A change in the relationship with any of our key suppliers or the unavailability of key products at competitive prices could affect our financial health.
  6. We are affected by mall traffic and our ability to secure suitable store locations.
  7. We may experience fluctuations in, and cyclicality of, our comparable-store sales results.
  8. Economic or political conditions in other countries, including fluctuations in foreign currency exchange rates and tax rates may adversely affect our operations.
  9. The United Kingdom electorate voted to exit the European Union in a referendum, which could adversely affect our business, results of operations and financial condition.
  10. Macroeconomic developments may adversely affect our business.
  11. Instability in the financial markets may adversely affect our business.
  12. Material changes in the market value of the securities we hold may adversely affect our results of operations and financial condition.
  13. If our long-lived assets, goodwill or other intangible assets become impaired, we may need to record significant non-cash impairment charges.
  14. Our financial results may be adversely affected by tax rates or exposure to additional tax liabilities.
  15. Changes in tax laws could materially affect our financial position and results of operations.
  16. The effects of natural disasters, terrorism, acts of war, and public health issues may adversely affect our business.
  17. Manufacturer compliance with our social compliance program requirements.
  18. Complications in our distribution centers and other factors affecting the distribution of merchandise may affect our business.
  19. We are subject to technology risks including failures, security breaches, and cybersecurity risks which could harm our business, damage our reputation, and increase our costs in an effort to protect against such risks.
  20. Risks associated with digital operations.
  21. The technology enablement of omni-channel in our business is complex and involves the development of a new digital platform and a new order management system in order to enhance the complete customer experience.
  22. Our reliance on key management.
  23. Risks associated with attracting and retaining store and field associates.
  24. Changes in employment laws or regulation could harm our performance.
  25. Legislative or regulatory initiatives related to global warming/climate change concerns may negatively affect our business.
  26. We may be adversely affected by regulatory and litigation developments.
  27. We operate in many different jurisdictions and we could be adversely affected by violations of the U.S. Foreign Corrupt Practices Act and similar worldwide anti-corruption laws.
  28. Failure to fully comply with Section 404 of the Sarbanes-Oxley Act of 2002 could negatively affect our business, market confidence in our reported financial information, and the price of our common stock.

 

C’mon Man!!!

There are many potential risks and rewards associated with attending a small college. Given my current patient and prudent positioning, I’d like to remain focused on the risks. There is one risk in particular that my high school counselor neglected to share with me. It’s a significant risk that I didn’t fully appreciate until after I enrolled in my small college of choice, Stetson University. It’s a risk and sacrifice I endured throughout my college career and for most of my adult life. I’m referring to the risk of loss — in fun and excitement — associated with missing out on big-time college football games.

As with most risks, there are ways to hedge. A popular small college hedging technique is adopting another team as your own. For example, most of the Stetson University alumni I know root for University of Florida, Florida State, or University of Miami. While adopting another college team may suffice for some, it doesn’t have the same fandom feel that comes with attending the school or being an alumni.

Another option for small college students and alumni is shifting their game-day focus from Saturday to Sunday. In other words, become an NFL fan. This is the option I selected after graduating from college and moving to Jacksonville, Florida. Shortly after my arrival, the city of Jacksonville was awarded an NFL franchise. Since I didn’t have a college team I could legitimately root for, I eagerly adopted my new NFL team, the Jacksonville Jaguars.

The Jaguars were pretty good in the early years (first season 1995), making it to the AFC Championship in 1996 and 1999. Since then, the team really hasn’t done much. In fact, they’ve been pretty awful since 2008, suffering through a nine year playoff drought. Interestingly, the Jaguars losing streak started about the same time the Federal Reserve launched its Quantitative Easing (QE) program and the current market cycle began. It’s unfortunate, but I seem to be the only fan that has made this connection. To this day I have not received a single high-five after yelling my favorite chant, “End the Fed! Quantitative easing and the Jags losing streak is perfectly correlated!” I often wonder what will happen first, the Federal Reserve loses credibility and the current market cycle ends, or the Jaguars make it to the playoffs? I’m not sure, but thinking about either possibility brightens my day!

Similar to most NFL fans, I like to watch Monday Night Football. Before the game, I often watch ESPN’s Monday Night Countdown. A popular segment of the program is called “C’mon Man”.  During this segment, the ESPN crew reviews the most outrageous and often humorous NFL highlights of the week. If you haven’t seen the show, I provided a sample below.

C’Mon Man Link

I thought of ESPN’s “C’mon Man” while reading some of last week’s top financial news. At this stage of the market cycle, few things surprise me. As asset prices often write the financial news, I expect the outrageous and at times even humorous. That said, even I was caught off guard by the number of “C’mon Man” moments last week. While there were too many to discuss in one post (I try to keep to 1000 words or less), there were several I thought were worth highlighting.

My favorite of the week came from the FOMC minutes released on Wednesday. In the minutes, some Fed members expressed their concern about valuations, stating equity prices were “quite high”. Is this the same Fed that has kept the federal funds rate below 1% for over eight years, encouraging investors to chase yield and inflate valuation multiples?  Is this also the Fed that “fixed” the bond market by purchasing $3.6 trillion of mortgages and USTNs, lowering yields and providing speculators with “relative” valuation cover? And isn’t this the same Fed that has transformed QE into an accepted monetary tool for global central banks, with the ECB and BOJ continuing to buy hundreds of billions of public and private assets a year? And now some Fed members are concerned asset prices are “quite high” after they, along with other global central banks, have completed over $12 trillion in asset purchases? C’mon Man!!!

Federal Reserve members also discussed the possibility of shrinking their bloated balance sheet. It was only two quarters ago that the Fed was openly discussing expanding its asset purchases to include corporate stocks and bonds during the next downturn (See post: Fed Raises Facebook to Strong Buy). In September Reuters reported, “The Federal Reserve might be able to help the U.S. economy in a future downturn if it could buy stocks and corporate bonds, Fed Chair Janet Yellen said on Thursday.” The Fed has gone from discussing the possible benefits of buying stocks and bonds to now contemplating reducing its balance sheet. What has changed over the past two quarters? The economy must have improved, right? It has not. In fact, economic growth has slowed considerably from 3.5% in Q3 2016 to current expectations of less than 1% (the Federal Reserve Bank of Atlanta is forecasting 0.6% growth for Q1 2017). If it’s not the economy, what is driving the Federal Reserve’s balance sheet narrative? While GDP growth has slowed considerably over the past two quarters, the S&P 500 has actually increased from 2160 to 2355 and the Russell 2000 is up from 1251 to 1364. Is it possible that asset prices, not the economy, are the main determinant influencing monetary policy? If so, C’mon Man!!!

William Dudley of the Federal Reserve Bank of New York was also busy last week. According to Bloomberg (link) William Dudley stated, “Free college is a ‘reasonable conversation’ to have.” With student loans reaching $1.4 trillion, student debt is a growing problem. Another issue is fewer students are paying back their loans. While there are many possible explanations, the belief that student debt will eventually be forgiven must be a major contributing factor. With politicians frequently waving the free college carrot in front of voters, it’s difficult to blame students for believing their debts will be forgiven. Politicians discussing free college doesn’t surprise me, but central bankers who actually have the ability to make anything “free” with an effortless stroke of the QE pen? C’mon Man!!!

Also last week, Panera Bread (PNRA) announced it was going to be acquired by JAB Holding Co. for $7.5 billion. JAB paid 19x EV/EBITDA, 32x EV/EBIT, and 49x earnings. Wow! I suppose these sort of valuations can make sense for a business growing rapidly. However, based on Panera’s slowing revenue and earnings growth over the past three years, its concept appears to have matured considerably. Although extremely low interest rates can make almost any acquisition look appealing on a spreadsheet, 19x EV/EBITDA for a maturing business in a saturated, hyper-competitive, and slow-growth industry? C’mon Man!!!

And finally last week, there was the taunting of short sellers by Tesla’s CEO, Elon Musk. Overconfidence is extremely dangerous in business and investing. Not to mention taunting is bad for the karma balance (and no, you can’t replenish your karma balance with a secondary offering). Mr. Musk should know better. C’mon Man!!!

Considering the current investment environment, I’m certain there are many more outrageous and humorous financial market moments on the way. It will be difficult, but I’ll try to keep up!

With all kidding aside, at this stage of the market cycle, humor can be an effective tool in helping absolute return investors manage through their difficult and frustrating opportunity sets. Instead of taking some of the news and events too seriously, sometimes it’s better to just laugh and say, “C’mon Man!”

Earnings Season Approaches

I recently reviewed UniFirst’s (UNF) quarterly results. I thought it was a good summary of what I’m expecting this earnings season. Furthermore, while I have no idea what tomorrow’s job report will show, the uniform companies aren’t a bad place to look when analyzing employment trends. Cintas (CTAS) also announced earnings recently. Cintas reported solid results, but spent most of its conference call talking about its G&K Services acquisition. UniFirst discussed the current operating environment in more detail and generated results that I believe closely resemble the broader economy.

UniFirst’s core laundry business grew revenue 2.2%. A low single-digit growth rate is commensurate with a mature economic cycle and what I’m expecting for nominal GDP this quarter. Management noted its business is stabilizing, particularly in its energy-related markets. As I’ve stated in past posts, corporate earnings growth in recent quarters has been aided by easy comparisons in energy-related and industrial businesses.

As it relates to its energy markets, management stated, “UniFirst witnessed significant uniform wearer losses in the niche markets over the last couple of years that affected our top and bottom lines. But more recently, we’ve been seeing not only stabilization in these areas, but actually some slight gains in energy-related uniform wearers. It would be premature for us to project any future growth opportunities in these volatile markets, but these modest improvements in uniform wearers have been more than welcome to say the least.”

The rebound in energy-related business shouldn’t be surprising. According to Baker Hughes (BHI) the average rig count for February 2017 was 744, up from 683 in January 2017 and up 212 from 532 in February 2016 (a 40% increase from a year ago). With many exploration and production companies hedging a meaningful portion of this year’s production, I believe capital expenditure budgets for 2017 will remain relatively stable. As such, I expect easy comparisons in energy-related businesses to continue for the next couple of quarters (rig counts bottomed in May-June 2016).

UniFirst also noted they were optimistic as it relates to government and policy. Management stated, “We are also hopeful that with the new presidential administration, national employment levels and the overall economy will soon begin reaping the benefits as a result of its new policies and from loosening up some of the business-related regulations. So we are watching these areas very closely as we move forward to identify any potentials for additional business and related growth opportunities.”

Has growing optimism spilled over into improving business trends? “From the customer visits that we’ve been making over the last quarter, I think there’s a general business hopefulness that this gentleman and the President of the United States will spend some money on infrastructure and maybe military spending to get more jobs going, but everybody is kind of wait and see.”

On rising costs and wages management stated, “They really have been filtering in. I think a number of states have increased minimum wages. And although most of our employees are above those minimum wages, it does cause sort of a wage compression right up the chain. And so we’ve been moving and having to pay more to hire certain positions from the production level up through the service level.

Management also noted they expect pricing to improve after Cintas recently acquired G&K Services. When asked about the acquisition management said, “I think we’ll get a little more rationality on the pricing side.”

Management commented on the current operating environment, stating, “Yes. We would say we’re operating right now in more of a normal environment, which is not really a big pull from wearers, but it’s not a drag either, so sort of stable and that’s our assumption. Ron mentioned we are seeing some pockets of positive adds in some of the energy markets, but again not overly significant. So we don’t have anything built in that’s a big pull or tailwind.”

And finally, I thought the following comment related to the reduction in growth caused by lower energy-related sales was interesting. In effect, management believes lower energy-related sales reduced the company’s overall organic growth rate by 1% (from 3% to 2%). In my opinion, this is similar to what the overall economy experienced with a 1% reduction in GDP after the energy credit boom turned to burst (GDP was averaging 2-3% before the energy bust and 1-2% after).

Specifically, management stated, “What I will say is that we’re 2 quarters in now to really not having seen those reductions from the energy sector. And once we sort of get another couple of quarters through, we’ll sort of have annualized that impact…without some of those reductions, our organic growth probably would have been in about that 3% range” [currently growing 2% organically].

In conclusion, I’m expecting this quarter’s earnings season to be similar to Q4 2016, with slow to moderate earnings growth on average. I’m expecting organic sales growth and nominal GDP to remain slow, in the low single-digits. The economy isn’t in a recession, nor is it booming. I believe we will also continue to see a growing dispersion between industries. As noted last quarter, energy-related and industrial businesses will benefit from easier comparisons – some growth should be anticipated. I also expect consumer discretionary businesses will continue to struggle, with companies more closely tied to asset inflation, such as home improvement, performing better.

I will provide a more detailed overview of current operating trends as the facts and earnings reports roll in. Similar to last quarter, I’ll also try to put together a summary of company operating results. I know these summaries are long, but if you can find time to read them, I think you’ll find it worthwhile. I continue to believe economic data derived from hundreds of operating companies is more timely, accurate, and valuable than government data.

For those attempting to guess tomorrow’s job number, good luck! Given all of the adjustments made to the data, I have no idea what the government will report. However, based on the results of the uniform companies, I wouldn’t be surprised if the number shows some improvement, especially in wages. I continue to see wage pressures and have been curious as to why this hasn’t showed up in the government data. Maybe tomorrow…

[Update: Friday’s job report showed hourly wages increased 2.7% year-over-year]

The Economics of Different

I grew up in a small town outside of Louisville, Kentucky. I’m not even sure I’d call it a town – more like a zip code. We lived in a subdivision with 5-10 acre lots and gravel roads. Growing up on a gravel road had its challenges. Have you ever fallen off your bike on a gravel road? Ouch! Walking or running on gravel isn’t particularly pleasing either, with rocks consistently finding their way into your shoes. Dust was an issue too, along with bumps and potholes. But there were some benefits.

While waiting for the school bus, the kids on our street played a game that consisted of throwing rocks at a street sign. It was a simple and fun game. How many times could you hit the sign before the bus arrived? The street sign was long, but very narrow – it was a tough shot. Hitting the sign before getting on the bus was always a nice start to the day.

I thought of my old bus stop this morning after driving past a group of kids waiting for their school bus. Instead of playing games and throwing rocks, they were all staring down at their smartphones. No one was moving or saying a word – they were frozen. What were they so focused on? Were they texting each other? Were they reading my blog? I wasn’t sure, but it really made me appreciate my childhood and growing up on that old gravel road.

Whether throwing rocks at signs or gazing into smartphones, kids tend to do what other kids are doing. Little changes as we get older. In past posts, I’ve frequently discussed how career risk and groupthink influences investor behavior. The investment management industry is not alone in its tendency to conform. Look at every industry and you’ll often find companies mimicking and following each other. Whether it relates to management compensation, acquisitions, buybacks, leverage, and general corporate strategy, most companies herd together and think and look alike.

The energy industry is a good example. I’ve been following energy companies closely since 1996. One thing I’ve learned is if I know what one energy company is doing, I’m fairly confident in what the entire industry is doing. For instance, during 2006-2008 natural gas prices were elevated and the shale revolution was picking up steam. The industry was enthusiastically buying and drilling natural gas properties. Although two consecutive cold winters delayed the inevitable, eventually natural gas supply spiked and prices fell. Suddenly spending heavily on natural gas properties no longer looked nearly as attractive.

The price of oil did not follow the decline in natural gas, with oil trading above $90/bl for most of 2011-2014. In response, the energy industry moved together again, sharply curtailing natural gas exploration and production in favor of oil. As natural gas properties were abandoned, the industry rushed into oil rich basins such as the Bakken and Permian. Acquisition and acreage prices soared. Similar to the natural gas boom, the rush to drill for oil eventually caused production and supply to spike, which contributed to a sharp decline in oil prices. The energy industry responded in unison again, slowing production, drilling within cash flows, and selling assets and equity at depressed prices.

Imagine for a moment an energy company that acted differently over the past ten years. I can’t think of one, so imagination is important in this exercise. What if our imaginary energy company didn’t aggressively grow production and buy new properties during the natural gas and oil booms? What if this company didn’t take on considerable debt like its peers? Instead of using its cash flow during the booms to buy new properties and drill aggressively, what if our company let cash flow accumulate on its balance sheet. Instead of selling assets and issuing equity near the industry’s trough, what if our imaginary energy company used its strong balance sheet to opportunistically purchase distressed assets during the bust? In effect, what if our energy company didn’t conform and did the opposite of its peers over the past ten years? I think it would be in pretty good shape right now and would have created tremendous value.

The energy and investment management industries have several things in common. Both industries are highly cyclical, with long histories of extreme booms and busts. Participants in both industries also have a tendency to allocate capital based on unsustainable trends – extrapolation risk is elevated. While the investment management industry has not experienced the same volatility as the energy industry over the past eight years, I don’t believe the degree of cyclicality between industries differs meaningfully. For example, a decline in price to normalized earnings (pick your favorite cyclically adjusted PE) from 30x to 15x wouldn’t be too dissimilar from oil falling from $100 to $50. With all-in costs near $50/bl for many energy producing regions, $50 oil makes a lot more sense to me than $100, just as 15x normalized earnings would for stocks. In my opinion, investors currently paying 30x normalized earnings for equities are no different than a CEO of an energy company buying oil properties in 2011-2014 and extrapolating $100 oil.

Similar to our imaginary energy company we discussed earlier, let’s now imagine an investment management firm that refused to conform and invested differently. What if instead of firing its active managers and replacing them with robots and a passive mindset, the asset management firm encouraged independent and unique thinking? Instead of hugging a benchmark and remaining fully invested, what if the firm invested in a flexible manner that allowed its managers to sidestep future losses and take advantage of future opportunity? What if there was an imaginary investment management firm that was willing to lose assets under management if that’s what was required to remain disciplined? Similar to our imaginary energy company, I believe this asset management company would be in pretty good shape over a full industry cycle.

While positioning a business differently can be very difficult during certain stages of an industry’s cycle, it also can be very rewarding. Given the duration and extremes of the current bull market, I believe the economics of different will be particularly attractive and evident once this cycle inevitably concludes.

The Mullet Discount

I’m often asked if I meet with management of the companies I analyze. I typically do not. Given the large number of stocks I follow (300 name possible buy list), traveling the country visiting corporate headquarters simply isn’t practical. However, I will call management when I have questions. My questions are usually relatively simple and are meant to help me better understand the company’s profit cycle.

While I’m sure one-on-one meetings with management has its benefits, there are risks as well. CEOs in particular can be very charismatic people. Many are simply enjoyable to be around and are likable. It’s often a reason they made it to the top of their organization, especially if the business has a strong emphasis on sales and marketing.

I’ve also found when I spend the time and money visiting a company, I’m more inclined to want to recommend the stock. In other words, the higher the sunk costs on an investment idea, the higher the risk decision making is influenced. This is a risk analysts should be aware of even without visiting a company. It’s harder to say no to an investment idea you’ve worked on for several weeks versus a few hours.

Early in my career when my possible buy list was much smaller and I was encouraged to travel, I met with CEOs and management teams more frequently. I was working in New York, which provided me with access to many management teams. During my first few meetings as a buy-side analyst, I remember being a little uncomfortable. I was only 25 years old and was asking experienced and accomplished CEOs questions that often challenged their corporate pitch. And as young analysts often do, I sometimes asked some really stupid and inappropriate questions.

I remember having lunch with the founders of a chain of Papa John’s restaurants. They had accumulated a large number of franchise stores and were going public. I’ll never forget it. We were just seated for lunch and I found myself sitting next to the CEO. Here was my chance to prove I had what it took to be a world-class equity analyst. But no, it wasn’t to be. I had to open my mouth and ask a completely irrelevant and idiotic question.

As a consumer of Papa John’s pizza, I was always curious about the nutrition content of the giant tub of butter they distribute with each pizza. As an analyst trying to prove himself in front of his peers, one of my first questions of a real live CEO was, “So how many grams of cholesterol are in that tub of butter?” I immediately knew it was a stupid question. The CEO didn’t even respond. Instead, he gave me this look that said, “Who let this punk kid in here? And why is he sitting next to me?” I didn’t say another word and left after finishing my complimentary and delicious decaf (side note: Roadshows have the best coffee! Coincidence or does Wall Street really want us wired so we make rash decisions?).

Although I eventually learned to ask more appropriate questions, I continued to find a way to stick my foot in my mouth. I remember a CEO giving me an energetic pitch on their company’s growth plans. It was as if he was reading me a script from an infomercial. I’m not sure exactly why, but I felt comfortable pointing out the obvious. So I looked at him with a smile and said with a friendly tone, “You’re so full of $#^@.” Fortunately, instead of punching me, we both had a good laugh. I was a little embarrassed by my abrupt comment, but he was full of $^#% and we both knew it. Once it was out in the open, we were able to have a very productive conversation.

There’s nothing wrong with promotional CEOs, as long as you know you’re being sold. Some of the best companies are managed by successful salespeople. Their business and industry may require it. Furthermore, properly communicating a business strategy is an essential role of the CEO. The more educated investors become, the more comfortable they will be allocating capital to the business. Companies with an attractive cost of capital have competitive advantages. In addition to higher equity compensation for employees, a high valuation and low cost of capital benefits a company’s merger and acquisition strategy (not to mention avoiding being acquired). Furthermore, companies with lower cost of capital typically have more financial flexibility and are considered lower risk business partners.

One of the things I really like about following and analyzing a relatively fixed opportunity set, is over time I get a good feel for the management teams of each business. Who are the charismatic promoters, who are the detailed accountants, and who are the book-smart engineers? They’re all different and require different analytical filters. It’s our job as analysts and investors to sort out management personalities and adjust our valuation assumptions accordingly. It’s also important to know your biases. You may like the promoter, or you may like the boring no-nonsense CEO. We all have our favorites, so we need to be careful applying discounts and premiums to management teams based on likability instead of capability.

Speaking of investor biases, several years ago there was a company that I really liked, but seemed to be out of favor with investors. It was a great business with a strong balance sheet and consistent free cash flow. When I started my research I couldn’t understand why the business was selling at such a large discount to my calculated valuation. What was I missing? I had a theory. The CEO had a very noticeable and thick Southern accent. When he said “percent” it sounded like “purrrrCENT”. You can imagine how many times a CEO says “percent” on a long conference call. To this day, I believe investors were applying a Southern drawl discount to their stock. Considering I grew up in Kentucky and proudly sported a mullet throughout most of my wonder years, I didn’t apply a similar discount. In fact, given the high-quality nature of the business, I applied a premium (lower required rate of return). Eventually its valuation gap closed, making it one of my larger winners on a purrrCENTage basis. In conclusion, while investor management biases can be a risk, they can also lead to opportunity!

Do Something Do Nothing

There are many things absolute return investors have in common. For instance, most absolute return investors prefer avoiding crowds, as crowds and value rarely coexist. Theme parks are a good example. Have you been to Disney lately? Along with the crowds and long lines, you’ll find high and rising prices. In fact, according to Bloomberg, Disney recently announced it was raising park prices 1.9% to 4.9%.

As a dedicated contrarian and absolute return investor, I prefer Legoland over Disney. At Legoland you will find fewer crowds, shorter lines, and lower prices. In my opinion, it’s simply a better value relative to risk assumed. We’ve been several times and went again last week for spring break.

During our visit I didn’t spend much time monitoring the markets. However, out of curiosity, on Thursday I decided to break away from the rides to take a glance. I should have stayed on the roller coasters! Investors appeared confused. Should they buy stocks in anticipation of the reliable quarter-end entitlement rally or should they sell stocks as Trump euphoria shows signs of fatigue?

It is times like these that I’m very grateful I’m not required to be fully invested in inflated assets. With my absolute return portfolio currently positioned 100% in patience, I’m not very concerned about the near-term direction of the stock market. It can spike higher or it can crash. To accomplish my absolute return objective, the exact heights equity prices reach this cycle is irrelevant. It will be the prices I ultimately pay when I allocate capital that will determine my future returns.

While I’m comfortable ignoring the markets and remaining patient for an extended period, I admit I’d prefer being fully invested in wonderful businesses selling at attractive valuations. Unfortunately, owning a portfolio of high-quality small cap businesses at today’s prices is off limits. My process and discipline is very clear about this – overpaying is not an option. Therefore, while I prefer being invested, during periods of rotating bubbles and broadly dispersed asset inflation, large allocations to patience, or cash, is often necessary.

Relative return investors view patience and cash differently. Regardless of valuations, most relative return investors remain fully invested throughout the entire market cycle. As an absolute return investor, this has never made sense to me. Think of all of the rules of successful investing, such as: buy low sell high, don’t lose money, or be fearful when others are greedy and greedy when others are fearful. What do all of these rules require? Patience. And how can investors be patient without the ability and willingness to hold cash?

With equity prices and valuations near or at all-time highs, instead of selling high, avoiding losing money, or being fearful, most active managers appear to be all-in with mutual fund cash levels near record lows (approx. 3%). While many of our investment heroes preach the importance of being patient and selective, when I open the hood of many actively managed funds, I see signs of “full throttle” late-cycle investing.

It’s understandable. In extended bull markets, the pressure and urge to do something and keep up with the herd can be overwhelming, while the rewards of being patient and doing nothing appear nonexistent. But doing nothing is exactly what I believe is required during periods of inflated asset prices. Why force invest in inflated assets if you don’t have to?

Unfortunately, many portfolio managers feel that they don’t have a choice and must remain fully committed. To some extent, this is true. Due to investment mandates requiring managers to be fully invested, a portfolio manager’s view on valuations, opportunity sets, and future returns may be irrelevant when determining the amount of cash a manger holds.

The growth in passive investing has also placed increasing pressure on managers to keep up during market cycle booms. Passive funds are aggressive competitors that do not care about valuation, do not hold cash, and are incapable of practicing patience.

I’m sympathetic to the position relative return investors find themselves in at this stage of the market cycle. Although many professional investors may be well aware that their opportunity sets are expensive, career risks often override investment risk concerns (thanks to a reader for sending the following article on career risk: link.) Jeremy Grantham (the leading expert on career risk) writes, “The central truth of the investment business is that investment behavior is driven by career risk.” In effect, for many professional managers, looking different is simply too risky from a business and asset under management (AUM) perspective.

I often wonder if the modern-day goal of risk management is to monitor the risk of losing assets under management instead of the risk of incurring losses on client capital. I’ll never forget being told after a good year of performance and bad year of asset under management growth, “Eric, you can make the best dog food in the world, but if the dog won’t eat it, it doesn’t matter.”

Regardless of the business challenges associated with absolute return investing, I’ve spent most of my career committed to maintaining the flexibility to hold cash and avoid overpaying. My absolute return objective attempts to protect capital during periods of inflated asset prices and act opportunistically when being adequately paid to assume risk. To achieve this objective, holding a large cash weight during certain portions of the market cycle has been required.

There are times when my process and discipline has been labeled a broken clock. Whether intended to be or not, I view this as constructive criticism and an important reminder of how absolute investors should not be positioned. Given cash is an awful long-term investment, I believe it’s important to avoid remaining patient throughout an entire market cycle. There should be a period during each market cycle when investors are being adequately paid to assume risk. In other words, during every market cycle, there is a time to be patient and a time to be opportunistic. Full-cycle broken clock investing should be avoided, while flexibility and decisiveness should be embraced.

Lastly, I want to make clear that my patient positioning is not an attempt to time the market. Instead, portfolio positioning is a direct reflection of the number of stocks within my universe of high quality small-cap business that pass my absolute return hurdle rates. It’s also important to be aware that holding cash can result in significant opportunity cost. However, during periods of excessive overvaluation, I believe opportunity cost is preferable to overpaying and risking substantial losses to capital. Furthermore, I’ve found opportunity cost can be quickly recovered once market cycles conclude and prices adjust. Conversely, significant losses resulting from overpaying can be much more difficult to recover from and can even be permanent.

In conclusion, I continue to prepare for the future as current prices and valuations do not interest me. As has been the case in past cycles, I expect equity valuations will ultimately normalize, causing price dislocations and sufficient opportunity. Although my patient positioning may cause my absolute return portfolio to lag the markets, I believe it is essential in achieving my objective of generating attractive absolute returns over a full market cycle. Patience and cash allows me to limit mistakes during periods of overvaluation and act decisively (without selling existing holdings) when opportunities return. While cash can be extremely boring during market manias and relentless bull markets, allocating it when prices plummet and the bids disappear can be extremely rewarding. I can’t wait! On second thought, I think I can and I think I will.

Perception Risk

A friend emailed me a Bloomberg article last week regarding the next “big short” in retail-backed mortgage securities. The article stated, “Wall Street speculators are zeroing in on the next U.S. credit crisis: the mall.” It was a good article and flowed as I expected. In effect, retailing is in trouble, malls are in trouble, so short retail-backed mortgages. Although it makes sense to me, successful shorting is not on my list of career accomplishments. I have a pretty good record of spotting overvaluation and asset bubbles, but accurately predicting the tides of investor sensibility continues to elude me. As I’ve mentioned in past posts, instead of looking for trouble by shorting overvaluation, I prefer avoiding it and taking advantage of the inevitable bust.

As the Federal Reserve increases the fed funds rate and communicates further rate increases are on the way, I’ve been collecting an increasing amount of evidence suggesting many consumer-related businesses continue to struggle. It’s a trend I noticed and documented last year. In October I wrote, “If my theory on a weakening consumer holds, I believe more consumer discretionary businesses will report challenging operating results in Q3. If I was forced to play the game and had to be invested, I’d be extra careful owning seemingly inexpensive consumer discretionary companies with questionable balance sheets. There are no free lunches at this stage of the market cycle. If it looks cheap, it’s most likely cheap for a reason. There are thousands of desperate investors currently scavenging for any crumb of value they can find.”

The weakness I noticed in Q3 2016 was not a one quarter occurrence, as many consumer companies continue to report weak sales comparisons and traffic trends. Last week I listened to several consumer company conference calls including, Stein Mart (SMRT), DSW Inc. (DSW), and Casey’s General Stores (CASY). All reported challenging operating environments.

Stein Mart (SMRT) reported comparable-store sales decreased -5.5%. For the year, same-store sales declined -3.8% due to a “decline in transactions, which was driven by traffic.” Stein-Mart appears to be taking a page out of Kohl’s (KSS) playbook, by reducing inventory and promotions, with Stein-Mart’s average inventory per store declining -5.9%. Inventory per store is expected to decline again in 2017. Management noted on their conference call, “Having less inventories will certainly give us that much less to clear at the end of season.” While fewer markdowns and promotions may help gross margins in the near-term, I doubt lower inventory and higher prices will help declining traffic.

DSW Inc. (DSW) generated similar results with comparable sales declining -7%. DSW is also reducing inventory in an attempt to enhance margins. Gross margins increased 0.5% in the quarter, while inventory per square foot decreased -8%. It will be interesting to see how long the increasingly popular strategy of reducing inventory and promotions can be maintained. In theory, it can’t continue indefinitely as eventually there won’t be enough inventory to sell. In fact, it could be a good time to buy a suit and pair of shoes. With inventory declining in the high single-digits, not only will discounting be less likely, you may have trouble finding your size! I believe the trend towards lower inventory also supports the investment thesis of shorting retail-backed mortgages. Less inventory = too much retail space = more store closures = stress on retail-related mortgages.

Casey’s General Stores (CASY) reported same-store sales increased 3%. While positive, results were less than the company’s annual goal. Management noted Casey’s suffered from many of the same factors influencing results of other convenience and grocery stores. Management also stated the consumer seems anxious with uncertainties, such as healthcare, weighing on confidence. While discussing costs, management pointed out higher wages and payroll taxes. Price increases in certain items, such as coffee and pizza, were also mentioned. And finally, the consumer’s move to cigarette packs from cartons was discussed again this quarter, along with the shift to generics from branded (another sign of consumer stress).

The dispersion between the results of consumer discretionary businesses and elevated consumer confidence is interesting. It’s a strange environment. The economy is not in recession and the stock market is soaring (confidence high), yet operating results indicate growing consumer uncertainty. What is an absolute return investor to do?

My plan is to continue to adjust for consumer uncertainty through the use of cash flow normalization and scenario analysis. While some are more stable than others, in my opinion, most consumer companies are cyclical and should be valued accordingly. I believe it is particularly important to account for trough cash flows expected in the next recession and bear market.

It’s been a long time since investors experienced a recession or bear market. That said, there have been significant downturns in specific sectors. The most recent being in commodities (2014-2016). The bear market in commodity stocks is fresh in my mind as I bought several during this difficult period. I remember how investor psychology shifted from adoring commodity stocks in the early stages of the current market cycle, to despising them during its later stages.

During the bear market in commodity stocks, I focused on precious metal miners with strong balance sheets. Although valuations were very attractive, investor sentiment was extremely negative. Given the negative perception associated with owning the miners, it was difficult for many asset managers to purchase. It was simply too uncomfortable and embarrassing. To hold the miners, a portfolio manager needed to incur considerable perception risk.

In my opinion, perception risk is one of the most underappreciated risks professional investors encounter. Regardless of valuation, when a stock or sector is significantly out of favor, it can carry too much career and AUM risk to include in a portfolio. Even if a portfolio manager wants to own a specific investment, if it carries too much perception risk, it may be avoided in favor of a security that is deemed more acceptable by peers and clients.

I’ve often wondered if there is an unofficial security approval list circulating within the asset management industry. Stocks on the list may be pricey, but they’re comfortable to own and perceived to be good businesses. I’m sure you can think of a few off the top of your head (if not, try pulling up the top holdings of most popular benchmarks). Stocks not on the list may be attractively priced, but are perceived to be too risky or contrarian to hold.

With investors considering retail-backed mortgage securities as the next “big short” and the S&P Retail ETF down -2.5% YTD, negative sentiment in consumer discretionary stocks is building. Will consumer stocks, such as retailers, eventually be removed from the asset management’s approval list and be off limits to managers overly concerned about career risk and tracking error? Will certain consumer stocks become too embarrassing for professional investors to own? I certainly hope so. As an investor long liquidity and patience, I’d be thrilled to be able to take advantage of another sector bear market amplified by perception risk.

Bloomberg Survival Guide

It’s been several months since Bloomberg pulled the plug. After having access for 23 years, it was a tough breakup, but I survived. I want to thank everyone who helped by sending links and alternatives — especially the free ones! A friend sent me a new one today that I thought I’d pass on. It’s called QuickFS (link). It’s great for screens and a quick financial overview. If you have sites that can help those of us without big hedge fund incomes and Bloombergs, please send my way. If I get enough of them, I’ll put a list together and post.

Due to a busy schedule I’ve been unable to post this week. Unemployment has been considerably more hectic than I expected! I should be back next week. There’s a lot to discuss.

Have a great weekend!

 

Wall Street Price Targets

While researching a company today, I bumped into a chart that included the stock price and the average Wall Street price target (chart below). It provided me with a good early morning chuckle. I’m sure most of you have seen similar charts and have noticed the same thing. Specifically, Wall Street price targets are often highly correlated to stock prices. If a stock goes up, the price target goes up. If a stock goes down, the price target goes down. Tell me the price of a stock and I’ll tell you what Wall Street believes the company is worth.  It’s a very reactive valuation process, and in my opinion, not a very accurate one. It’s one of the many reasons I avoid sell-side research.

The company in the chart above missed Wall Street’s earnings estimate last quarter. Shortly after the stock declined, Wall Street analysts adjusted their earnings models and lowered their price targets. Reactive target adjustments such as these are made frequently on the upside and downside.

In my opinion, the reason Wall Street price targets are so volatile is due to their valuation methodology. Most Wall Street analysts use an earnings multiple, such as P/E or EV/EBITDA, and apply this multiple to their earnings estimate for next year. For example, an analyst may value Company XYZ at 20x its 2017 earnings estimate. Simple enough, right? Right. But here’s the problem. By using next year’s earnings as the foundation of a business’s valuation, one year of profit is being used to value a perpetual asset with many years of uncertain profits.

Operating results and profits change from one year to the next. Sometimes earnings volatility is structural, while other times it’s simply a natural part of a company’s profit cycle. For example, the company in the chart above is experiencing a near-term decline in revenues and earnings. Such fluctuations in the company’s operating results have happened in the past and should be expected in the future. Over time, revenue growth and margins have evened out, with the company reporting some good years and some bad. Instead of taking normal fluctuations in operating trends into consideration, analysts that value businesses on near-term earnings are often more concerned about what is happening now versus what will happen over an entire profit cycle.

By properly accounting for the natural volatility in revenues, expenses, and other variables that influence full-cycle profits, I believe investors can produce a more accurate and less volatile business valuation. Unlike their underlying stocks, the value of most established operating businesses are relatively stable and change infrequently. In theory, intrinsic values should grow as profits and free cash flows are reinvested into the business. Business values can also change due to shifts in organic growth and improvements in the balance sheet. However, for mature businesses, these trends are typically gradual and should not change noticeably from one quarter to the next.

Below is an example of a chart I’d expect to see with a high-quality business over a two-year period. While its stock fluctuates with the market and company-specific news, the value of the business is stable and grows gradually. It’s quite a bit different than the average analyst price target chart above, isn’t it?

In conclusion, operating results and margins can and do fluctuate over a profit cycle. By considering these fluctuations in advance through the use of profit normalization, I believe investors can improve the stability and accuracy of their business valuations. A more stable and accurate valuation provides many advantages including a higher batting average (winners vs. losers), lower turnover, an increase in valuation confidence, and improved decisiveness. Moreover, normalizing just makes sense, doesn’t it? I think so. And that’s my goal when determining a business’s value. I want to value a business in a manner that makes the most sense to me, not Wall Street.

Managing Mistakes

A reader recently asked me to talk about my sell discipline and past mistakes. It’s a good subject so I thought I’d do a quick post.

As I’ve stated many times, limiting mistakes is very important for absolute return investors. While we can’t eliminate them, I believe mistakes can be minimized by following some basic guidelines. Rules that have helped me limit mistakes include: refuse to overpay; understand and normalize profit cycles; use realistic valuation assumptions; avoid businesses that can’t be valued (i.e. unpredictable cash flows or unmeasurable liabilities); separate operating and financial risk; ignore benchmarks and peers; embrace patience; and finally, focus on established businesses with sufficient operating histories (necessary for accurate valuations).

While I believe these guidelines have improved my batting average considerably, I have and will continue to make mistakes. One of my favorite presentation slides listed all of my winners and losers since 1998 (defined as realized gains and losses). It was an interesting and unique slide, as it included every mistake I’ve made over the past 18 years. Fortunately all of my losers (highlighted in red) fit in one column. I found this slide very useful when communicating with clients and potential clients. A popular question or request for portfolio managers is, “Tell me about a mistake you made and what you learned from it.” I’d respond, “Turn to page 18. They’re all there. Which one would you like to discuss?” Wouldn’t this be an informative slide for all active managers?

One of my first and largest mistakes of my career was The York Group (YRKG). If my memory serves me correctly, it was a -50% realized loss. It was a meaningful loss on a full position and it hit me when I was already having a tough year (1999).

The York Group was a market-leading manufacturer of caskets, behind Hillenbrand. When I bought their stock it appeared to be the perfect stable business and industry – death care. How could I mess this one up? While growth was slow, revenues and cash flows were very predictable. Assuming you could get over the uncomfortable nature of the business, the death care industry had many attractive attributes of a high quality business. And Wall Street seemed to agree.

In the mid-90s, Wall Street was busy helping the market-leading death care companies (mainly funeral homes) consolidate. Wall Street was racking up investment banking fees and placed strong buy recommendations on almost every death care stock. Death care quickly went from a pile of boring low-growth private businesses to an exciting publicly traded growth industry! However, in the end, it was just another roll-up scheme that ultimately ended badly for many of the funeral home consolidators and investors.

I wanted to learn more about the industry, so I decided to attend one of the death care conferences in New York. I’ve never been to an investor conference quite like it. This was a group of companies rooting for a bad flu season. It was strange and a little uneasy, but ultimately I accepted that these were simply businesses providing society with necessary products and services.

I eventually became quite knowledgeable of many of the companies in the industry. After getting to know the industry better, I decided I didn’t want to own the funeral homes. They were expensive and I’d been investing long enough to know the risks associated with roll-ups and aggressive acquirers. Instead of buying the funeral homes and cemeteries, I focused on the companies that sold to them, like the York Group and Mathews International (caskets and bronze memorial plates).

So how did I lose money on what appeared to be a relatively low risk investment? To put it simply, things went wrong. First, the company lost a large contract to its largest competitor, Hillenbrand. While I knew this was a risk, I didn’t properly discount for the revenue concentration and contract risk (I should have used a higher discount rate in my valuation model). Furthermore, the negative operating leverage from the lost contract was greater than I expected (I should have used a lower worse case cash flow assumption in my scenario analysis).

In addition to the drop in revenues and earnings, the lost contract caused management to panic. To replace the lost revenues, York made a large acquisition of a bronze plate manufacturer.  The company took on debt and paid a healthy price. To make the acquisition work and improve profitability, management consolidated the bronze plate manufacturing facilities. The strategy backfired and caused bottlenecks and delivery issues. To make matters worse, York’s balance sheet was now leveraged with debt from the acquisition, limiting their financial flexibility.

My “sure thing” low-risk investment quickly transformed into a large unrealized loss with operating risk and financial risk. And this is when my sell discipline kicked in. When I purchased The York Group they had a strong balance sheet (low debt to cash flow) and low operating risk (very consistent business). After I purchased their stock, they eventually took on both forms of risk.

I’m comfortable assuming financial risk or operating risk, but never both. When investors assume both forms of risk, the probability of a business operating under distress or the threat of bankruptcy is elevated (leveraged energy stocks in 2015-2016 are great examples). As an absolute return investor, I never want to position myself to have a stock go to zero. Stocks can recover from a lot of things, but zero is not one of them. Avoiding and selling businesses with operating and financial risk has allowed me to keep goose eggs off the scoreboard and limit large losses.

Another reason I’ll sell is if I feel I can no longer value the business accurately. If something occurs while I own the business that creates too much uncertainty in cash flows, assets, or liabilities, I will sell the stock.

Lastly, I will sell a stock when it trades above my valuation and I’m no longer being adequately paid to assume risk. Fortunately, this has been the reason for most of my sells over the past 18 years.

Before I conclude, I want to touch briefly on averaging down on positions with unrealized losses. I will average down assuming I remain confident in my valuation AND my valuation is stable. If my valuation is in decline, I will not add to the position. If I’m forced to reduce the valuation of a business, I clearly got something wrong. Either my discount rate was too low or my cash flow and growth rates were too high. To protect myself from myself, I like to wait for my valuation to stabilize before adding to a position (I update my valuations quarterly).  I don’t want to be stubborn and buy a company all the way to zero (I call it pulling an Enron). My valuation in decline rule, helps me avoid emotional buying driven by my ego (yes, we all have them and they can be very dangerous!).

I hope my sell discipline and guidelines help you think of ways to reduce meaningful losses and mistakes. What’s that famous Buffett quote? Rule #1 don’t lose money. Rule #2, don’t forget rule #1. I really like that one as it fits the absolute return mindset perfectly!

I’m looking forward to the end of the current market cycle when we discover who has been following all of the rules of successful investing. During periods of inflated asset prices and extended market cycles, rules on minimizing mistakes aren’t very popular. Thanks to the reader for requesting and reminding me of its importance.