Non-Texas Non-GAAP Adjusted Results

The Texas economy is weak. This shouldn’t be a surprise given their exposure to the depressed energy industry. However, what is surprising is the number of companies blaming Texas for weak results this quarter. Interestingly, I don’t remember Texas being pulled out of operating results when its economy was booming (thank you Fed induced energy credit bubble).

One example of ex-Texas results came from Aaron’s (AAN) conference call last week, “In the quarter, same-store revenues were down 1.2%, and down 0.3% excluding Texas. This marks the fourth consecutive quarter of same-store revenue improvements. Texas had a pronounced negative impact on our comparable-store trends in the second half of 2015, and we are pleased to see improvement in both our Texas and non-Texas stores in the second quarter. Customer counts were down slightly on a same-store basis, and flat excluding Texas.”

I have nothing against Aaron’s. It’s a holding I’ve done well with and have owned numerous times (I do not own currently). And if management wants to disclose operating results for Texas, or every state for that matter, great – the more information the better. However, to be fair, I think it should be disclosed on both sides of the cycle.

Texas comparisons, along with energy related sales in general, will soon get easier for a lot of companies. For those companies pulling weak Texas and weak energy results aside this quarter, I hope this new information continues to be included once industry conditions improve and the energy drag becomes a benefit.

The Chicken and the Eggs

From Bill Gross today, “I don’t like bonds; I don’t like most stocks; I don’t like private equity.” Gundlach said practically the same thing last week and now Gross this week. Warren Buffett next week? I won’t hold my breath. In any event, my “Opportunity Set From Hell” post must have struck a chord with the bond kings! With all kidding aside, I couldn’t agree more with Gross and Gundlach and I’m invested accordingly. However, what I don’t understand is if Gross and Gundlach don’t like bonds, why are they still managing bond funds? Are the bonds they’re buying different? It’s the other bonds they don’t like? And if it’s all bonds they don’t like, why own any bonds?

Eight years of emergency monetary policies, ZIRP, and NIRP has certainly caused a lot of people, including professionals, to do some uncharacteristic things  – including buying bonds yielding next to nothing. Maybe Gross and Gundlach can pick fixed income securities that can generate a positive return even after the bond bubble pops. That would be impressive. However, if they say they don’t like bonds and then buy bonds to play the relative return game, that wouldn’t be so impressive.

I’d find it refreshing to see both of them stop playing the relative return game and join the absolute return team. Come on over – there’s plenty of room! If bonds are expensive, sell them. Take a stand against inflated asset prices, manipulated bond markets, and runaway train monetary policies. Maybe I just want a little company, but what I really want to see is a bond vigilante. I’ve read about them and would love to meet one. I continue to ask potential bond vigilantes, if not now, when?

Gross also mentions owning “real assets such as land, gold, and tangible plant and equipment at a discount”. I agree with this also. In fact, while I’m 100% cash in the absolute return strategy I manage (currently just my personal account), I also have exposure to tangible assets. However, I consider these outside of my managed assets, which remain very liquid and in cash (I own zero stocks personally). I believe if I’m going to hold cash in the current Wild West environment of central banking, holding some sort of cash hedge makes sense.

Although I can’t make specific recommendations, in my opinion, whatever a currency holder is most comfortable with and makes sense to them is a good place to start. I have a friend who owns commercial real estate and another that bought a McMansion on the water. Timberland may make sense for some. I used to own a timber REIT, Potlach (PCH) but they have a little too much debt for me now. Gold and silver are options. Farmland sounds interesting. I have a family member who bought recreational land as a cash hedge. Productive improvements to land and real estate (we did this) also makes sense to me. I have another friend who buys and fixes up old cars. Rental properties. There are plenty of options, but it’s up to the individual to decide if it’s necessary or what they’re most comfortable with and most knowledgeable about. Ideally cash holds its value and insurance isn’t necessary, but every time one of these central bankers talk, I can’t help but think their experiments aren’t going to land sunny side up.

I’ve joked with a friend that to hedge against global central bankers we should start a chicken farm. We’d profit handsomely assuming the world’s next reserve currency is the chicken and the egg! The chicken would be a $100 bill and eggs $20 (4 eggs), $10 (2 eggs), and $5 (1 egg). Go ahead and laugh, but you can’t print chickens and eggs. It might be messy paying the cable bill, however.

Economic Steak Indicator (ESI)

According to the USDA, meat consumption has increased 3% annually in developing and emerging economies since the mid-90s versus 0.4% in developed countries. The theory goes that with faster population and income growth, the demand for meat, or protein, expands. In effect, economic growth and demand for protein are correlated.

While I’m probably stretching this concept some, let’s also assume steak (protein) consumption and economic growth are correlated in the U.S. We’ll call it the Economic Steak Indicator (ESI). The ESI comes out every quarter after leading steak providers Ruth’s Hospitality Group (RUTH) and Texas Roadhouse (TXRH) announce earnings. The ESI measures the consumer’s willingness to spend discretionary income on an expensive steak. Combined, RUTH and TXRH cover broad regions and demographics. In case you missed it, the Economic Steak Indicator (ESI) was released today and it’s flashing pink red.

Ruth’s Hospitality Group (RUTH) actually announced earnings last week, not today. Their results and economic assessment were not as robust as past quarters. While comparable sales increased 2.3%, the gain was due to the average check increasing 2.9%. Traffic was weak and declined 0.5%. As we discussed in previous posts, I believe price increases are masking weakness in economic activity (traffic and volume) at several consumer companies this quarter. RUTH appears to be raising prices to offset higher costs. Management noted operating expenses were rising primarily due to higher labor costs which are being driven by minimum wage increases. Higher healthcare expenses were also mentioned.

Comments on labor were interesting and are similar to what several other companies have been discussing this quarter (productivity data supports as well). Management stated they were disappointed with the higher labor costs and lower revenue growth. Furthermore, they called the current economic environment “tough”.

In the Q&A session, management expanded on this by saying, “I think we’re seeing sort of a modest slowdown in all of our segments. I mean, so for instance, when we talk about private dining which is often a proxy for what’s going on with business travel, et cetera. It is still quite robust. It’s just not robust as it has been.” Management summed up their environment by stating, “Simply put, we faced slower revenue growth and higher year-over-year labor costs.”

Texas Roadhouse (TXRH) results were stronger relative to RUTH’s and the restaurant industry. However, relative to past results, TXRH showed a modest slowdown in growth. TXRH has been growing stores and comparable sales aggressively. It’s one of the few consistent growth stocks remaining in the restaurant industry. In 2015 it generated comparable restaurant sales growth of 7.2% at company restaurants and 6.5% at franchise restaurants. At 30x earnings TXRH is priced for growth.

Although growth slowed during the quarter, it was still above average with comparable sales growth of 4.5%. Looking ahead to next quarter, July comparable sales were slightly weaker, but still up approximately 3.7%. Management stated, “While this is a bit of a slowdown from early 2016, we are encouraged to see continued positive traffic growth along with solid comp sales trends on a two-and three-year basis.” Similar to RUTH, Texas Roadhouse pointed out rising labor costs, but noted food cost declined. Price increases were not up as much as RUTH with the average check increasing 1.6%.

In the Q&A session, management tried (without success) to come up with a specific reason for the slowdown in same-store growth. After an analyst inquired about slowing sales trends management responded, “I think as far as if you are looking at the most recent two-year trends, or even the most recent one-year numbers for us, 2% in June and 3.7% in July is definitely lower for us from what we have been experiencing. We don’t have the answer. We can only speculate. I can tell you, in our case, we are not operating any differently. We’ve got the same labor staffing, we’ve got the same food quality, we’ve got the same aggressive price points…”

“But I think anything about why as an industry or anybody specifically why sales might be tailing off I think is speculation. Everything from, is it related to there being a big shooting on TV every other day, it seems like, to the conventions, to the next thing we’ll be talking about the Olympics coming up in Rio.”

As management noted, they’re not doing anything different and aren’t sure why growth is slowing. Given similar reports from other consumer companies this quarter, I believe the slowdown in comps at TXRH is more likely tied to the economy than company-specific reasons. Although growth remains above average relative the industry, it appears investors were disappointed driving TXRH’s stock down 12% today. This is encouraging. I’d be interested in owning TXRH assuming growth investors continue to flee and drive its rich valuation down further.

In conclusion, the Economic Steak Indicator (ESI) is showing signs of a slowdown and confirms what several other restaurants and consumer discretionary companies are reporting. While the consumer isn’t in a recession, in my opinion, there does appear to be signs of hesitancy and softening in consumer spending. Auto sales are plateauing as well. With many industrial and cyclical companies in recession (energy is in a depression), where will the economic growth come from to support the good ol’ second half hockey stick recovery? Along with the ESI, the majority of the 300 companies I follow aren’t seeing it either.

Woof! Woof!

One of my favorite slides in a presentation I gave frequently was the historical batting average slide. It showed all my winners and losers since 1998, with winners and losers being defined in absolute returns. It was a simple slide. Did I make money on the stock or not?

As an absolute return investor it’s important to limit mistakes. What was unique about this slide is it had every one of my mistakes since 1998 listed on one page. I say unique, because I don’t know of another manager with such a long history who discloses all of his or her losers. Given it was almost two decades worth of history, I’m very proud of the limited number of losers. Even though the winners significantly outnumbered the losers, I always found it interesting that the audience usually wanted to talk about my losers. That was fine. I enjoyed talking about them as it helped me communicate the investment process and what I learned from each mistake. It also helped that they all fit in one column.

We all make mistakes in investing. Mine were all listed for everyone to see. It was nice to have it all out there. Or was it all out there? While all of my realized losses were disclosed, there were other mistakes that are more difficult to measure, but mistakes nonetheless. I’m talking about missed opportunities. In other words, after analyzing and valuing a business, I decided not to purchase a stock that proceeded to do very well. To be fair, I also had a lot of ideas I passed on that I’m very glad I didn’t buy (remember RadioShack?). However, considering the current bull market is now over seven years old, it’s not surprising I remember more missed opportunities than missed disasters.

In a bull market, it’s easy to beat yourself up over a list of stocks you should have bought. One of the nice things about investing and missed opportunities is you often get a second chance. I’ve found this especially true with certain industries such as commodities. Whenever an energy stock passes me by I just wait for their cycles to revert. I’ve found commodity stocks are either significantly overvalued or undervalued – they rarely seem fairly priced. It’s one area where investors love to extrapolate cyclical growth too far into the future. When cyclical stocks are priced as growth stocks, run for your life and avoid at all costs. Eventually commodity price cycles revert and the stocks come crashing down, providing patient investors with a second chance.

While missed opportunities often come back around and you get a second chance, sometimes they don’t. This is what happened to me after I worked on VCA Inc. (WOOF) approximately three years ago. VCA is a market leading operator of animal hospitals and veterinarian labs. It’s a good business with consistent and growing revenues and earnings. There are few services less discretionary than spending on your pet’s health.

I forgot the exact date I placed VCA on my possible buy list, but I remember liking the business. I also remember the stock was trading in the $20s. I don’t remember exactly why I decided not to buy at that time, but it may have been because of their acquisition strategy. I’ve discovered that companies that like to acquire often stumble from time to time, usually after biting off more than they can chew. It is when they suffer from acquisition indigestion and their stock plummets that I like to buy them.

I also like to follow a stock for a couple quarters after putting it on my possible buy list. I find it helpful to follow a company in real time. Furthermore, it allows me to make sure I didn’t miss anything, but most important it allows me to get to know management (compare words and actions) and the company better. This helps limit mistakes and improve the accuracy of my valuation, but at times it can also lead to a missed opportunity.

Unfortunately waiting to get know the business better or waiting for a more attractive price didn’t work with VCA. Their business has performed well since my initial analysis. Since 2013 they’ve grown revenues 18% and net income 54%. Over the past three years the stock has more than tripled to $71. I recently read their last earnings call and found a couple interesting observations. Although this earnings season has been mixed, VCA has bucked the trend and continues to generate above average organic growth of 5% to 6%. I believe VCA is a good example of consumers’ willingness to spend assuming they have the means and the need. Pets’ health qualifies as a need for many pet owners and is not considered a discretionary item by most who can afford it.

While other more discretionary consumer companies are reporting mixed quarters, VCA management is seeing strong fundamentals. Management noted, “The industry continues to do very, very well. Great demand, the economy is improving, a strong consumer. And I think we’re seeing great business based on pets with a lot of natural demand.”

Is organic growth coming from a strong economy or the fact that, as management states, people just love their pets? I agree VCA is benefiting from inelastic demand, but it appears higher prices and customers willing to pay them is helping as well.

An analyst asked the following question as it relates to pricing (hospital division): “Can you talk about pricing across the industry? I’m hearing two trends from industry consultants. Number one, that pricing has gone up a lot in the industry in the last couple years compared to where has in the past. But number two, prices could go a lot higher without any pushback.”

Management replied that although pricing was up “4 point something percent” it was probably closer to 2% given “the doctors are doing more medicine”. Management concluded by saying that rising consumer confidence allows for higher prices. “When they [consumers] think things are better, they are more apt to accept a price increase and then also more apt to work cases up and do more quality medicine, which translates to a higher price…But I think your assumption is that it’s — there’s more inelasticity to it is absolutely correct. There is. You do have a little bit more pricing flexibility than you did in the previous five years.”

This reminds me a lot of the Tempur Sealy earnings call we discussed last week, with pricing being a large portion of organic growth. I suspect Tempur Sealy and VCA have a similar customer base. I don’t know the last time you took your pet to a veterinarian, but the last time I did it set me back about as much as a new mattress!

I believe there is building evidence that a limited number of consumer companies that are generating above average organic growth are doing it at least partially, if not mostly, on price (not necessarily traffic or volume). And the higher the consumer’s income level, or exposure to asset inflation, the more likely the customer can afford the price increase and provide the wonderful earnings reports we saw with Tempur Sealy and VCA.

Interestingly, Tempur Sealy and VCA have almost identical stock price charts since the launch of QE3. Coincidence? I’m not so sure. Their stocks and businesses have most likely benefited from QE and the resulting multiple expansions and asset inflation.

Once this market cycle ends a lot of missed opportunities will revert to more reasonable valuations and there will be a lot more second chances. Whether VCA ever trades at an acceptable discount to valuation, I don’t know, but I’ll be waiting for it with open arms and abundant liquidity.

Parachute Pants

Did your parents ever tell you not to worry about what other people think? I remember my mother telling me this when I was in eighth grade. I’m not sure if she was simply giving good advice or trying to talk me out of buying parachute pants. In the early 80’s parachute pants were a must have for the in crowd. I wanted to fit in, but my mom convinced me it wasn’t necessary to act and dress like everyone else. In hindsight, good call mom. Now if only she would have talked me into cutting off my glorious “Kentucky waterfall” mullet! The pressures of conforming and fitting in don’t go away after eighth grade – it sticks around many years thereafter. Investing is no different.

In the past I’ve discussed and written about the psychology of investing and the role of group-think. The pressure to conform in the investment management industry is tremendous, especially for relative return investors. As their name implies, these investors are measured relative to the crowd. One wrong step and they may look different. Looking different in the investment management business can be the kiss of death, even if it’s on the upside. If a manager outperforms too much, he or she must have done something too risky or too unconventional. For some relative return investors being different (tracking error) is considered a greater risk than losing money. Losing client capital is fine as long as it’s slightly less than your peers and benchmarks. From what I’ve gathered over the years, to raise a lot of assets under management (AUM) in the investment management industry, the key is looking a little better, but not too much better, and definitely not a whole lot worse.

How did we get here? Since my start in the industry, relative return investing has gradually taken share from common sense investing strategies such as absolute return investing. How well one plays the relative return game is a major factor in determining how capital is allocated to asset managers. I believe this is partially due to the growing role of the institutional consultant and their desire to put managers in a box (don’t misbehave or surprise us) and turn the subjective process of investing into an objective science. Institutional consultants allocate trillions of dollars and are hired by large clients, such as pension funds, to decide which managers to use for their plans. The consultants’ assets under management and their allocations are huge and have gotten larger over time, increasing the desire by asset managers to be selected. This has increased the influence consultants have on managers and how trillions of dollars are invested.

During my career I’ve presented hundreds of times to institutional consultants. While I have a very high stock selection batting average (winners vs. losers), my batting average as it relates to being hired by institutional consultants is probably the lowest in the industry. It isn’t that they don’t understand or like the strategy. In fact after my presentations I’ve had several consultants tell me they either owned the strategy personally or were considering it for purchase. Although they appreciated the process and discipline, they couldn’t hire me because I invested too differently and had too much flexibility and control (for example, no sector weight and cash constraints). In other words, they liked the strategy, but they were concerned that the portfolio’s unique positioning could cause large swings in relative performance and surprise their clients. In conclusion, in the relative return asset allocation world, conformity is preferred over different, as investing differently can carry too much business risk (risk to AUM).

Over the past 18 years the absolute return strategy I manage has generated attractive absolute returns with significantly less risk than the small cap market. Isn’t that what consultants say they want – higher returns with lower risks? Yes, this is what they want, but they want it without looking significantly different than their benchmark. This has never made sense to me. How can managers provide higher returns with less risk (alpha) by doing the same thing as everyone else? Maybe others can, but I cannot. For me, the only way to generate attractive absolute returns over a market cycle is to invest differently.

Investing differently and being a contrarian is easy in theory. When the herd is overpaying for popular stocks avoid them (technology 1999-2000). Conversely, when investors are aggressively selling undervalued stocks buy them (miners 2014-2015). It’s not that complicated, but in the investment management industry, common sense investment philosophies like buy low sell high have been losing share to investment philosophies and processes that increase the chances of getting hired. Instead of asking if an investment will provide adequate absolute returns, a relative return manager may ask, “What would the consultant think or want me to do?” I believe the desire to appease consultants and win their large allocations has been an underappreciated reason for the growth in closet indexing, conformity, and group-think.

In my opinion, the business risk associated with looking different has reduced the number of absolute return managers and contrarians. And some of the remaining contrarians don’t look so contrarian. For example, look at the four-star Fidelity Contra Fund. According to Fidelity this “contra” fund invests in securities of companies whose value FMR believes is not fully recognized by the public. Three of its top five holdings are Facebook, Amazon, and Google. I suggest the fund be renamed to the “What’s Working Fund”. With $105 billion in assets under management, one thing that is working is the sales department! Wow, that’s impressive. What would AUM be if the fund actually invested in a contrarian manner? My guess is it would be a lot lower, especially at this stage of the market cycle when owning the most popular stocks is very rewarding for performance and AUM.

I’m not just picking on Fidelity. The relative return gang is in this together. After the last cycle we learned most active funds underperformed on the downside. Given the valuations of some of the buy-side favorites currently, I suspect they’ll have difficulty protecting capital again this cycle once it undoubtedly concludes. This could be the nail in the coffin for active management. If the industry is unwilling to invest differently and they don’t protect capital on the downside, why not invest passively and pay a lower fee?

In my opinion, given the broadness of this cycle’s overvaluation, the most obvious and most difficult contrarian position today is not taking a position, or holding cash. In an environment with consistently rising stock prices and the business risk associated with holding cash, I don’t believe many managers are willing to be patient. That’s unfortunate because I’ve found the asset that is often the most difficult to own is often the right one to own. The most recent example of this is the precious metal miners.

After the precious metal miners crashed in 2013, I became interested in the sector and began building a position. Besides a couple positions I purchased during the crash of 2008-2009, I had never owned precious metal miners before. They were usually too expensive as they sold well above replacement value (how I value commodity companies). Miners are a good example of how quickly overvalued can turn into undervalued. In addition to selling at discounts to replacement cost, I focused on miners with better balance sheets to ensure they’d survive the trough of the cycle.

After the miners crashed in 2013, they eventually crashed again in 2014 and became even more attractively priced. I held firm and in some cases bought more in attempt to maintain the position sizes. After adding to the positions in 2014, they crashed again in 2015 and early 2016. I again bought to maintain position sizes. I’ve never seen a group of stocks so hated. Many were down 90% from their highs – similar to declines seen in stocks during the Great Depression. The media hated the miners with article after article bashing them and calling their end product “barbaric”. I haven’t seen many of those articles recently. The bear market in the miners ended in January. Today they’re the best performing sector in 2016, as many have doubled and tripled off their lows.

Owning the miners is a good example of how difficult it can be to be a contrarian. While clearly undervalued based on the replacement cost of their assets, there didn’t appear to be many value managers taking advantage of these opportunities. I thought, “Isn’t investing in the miners now the definition of value investing? Where did everyone go?” It was extremely lonely. Some investors argued they weren’t good businesses as they were capital intensive and never generated free cash flow. Obviously they’re volatile businesses, but after doing the analysis I discovered that good mines can generate considerable free cash flow over a cycle. Pan American Silver (PAAS) did just that during the cycle before the bust. As a result of past free cash flow generation, Pan American entered the mining recession with an outstanding balance sheet. New Gold (NGD) is another miner with a tremendous asset in its low-cost New Afton mine, which also generates considerable free cash flow. I also owned Alamos Gold (AGI). Alamos had a new billion dollar mine, Young Davidson, which was paid for free and clear net of cash and was expected to generate free cash flow. Alamos was an extraordinary value near its lows and was the strategy’s largest position in 2016.

Assuming a mining company had developed mines in production, generated cash, and had a strong balance sheet, I believed while the trough would be painful, these companies would survive and prosper once the cycle turned. They weren’t all bad businesses when viewed over a cycle, as all cyclical businesses should be viewed. Furthermore, many had very attractive assets that would take years if not decades to replicate. In the end, survive and thrive is exactly what happened for many of the miners this year. I sold several of the miners as they appreciated and eventually traded above my calculated valuations. The remainder were liquidated when capital was returned to clients.  It was a heck of a ride and was one of the most grueling and difficult positions I’ve ever taken. But it was worth it.

The reason I bring up the miners is not to boast, but to illustrate how difficult it is to buy and maintain a contrarian position in today’s relative return world. I believe it helps in understanding why so few practice contrarian investing, or for that matter, disciplined value and absolute return investing. During the two and a half years of pain (late 2013-early 2016), equity performance in the strategy I manage suffered. I initially incurred losses and was getting a lot of questions — I had to defend the position. Relative performance between 2012-2014 was poor (high cash levels also contributed to this). During this time, the strategy lost considerable assets under management. People were beginning to believe I lost my marbles. Whether or not I was going crazy is still up for debate, but one thing was certain, holding a large position in out-of-favor miners wasn’t encouraging flows into the strategy. While the miners were eventually good investments, in my opinion, they were not good for business.

As value investors we often talk about being fearful when others are greedy and greedy when others are fearful. However, in practice it’s extraordinarily difficult. In addition to the pain one must endure personally from investing differently, a portfolio manager also takes considerable career and business risk. Given how the investment and consultant industry picks and rewards managers, it can be easier and more profitable to label yourself as a contrarian or value investor, but avoid investing like a contrarian or value investor. Instead simply own stocks that are working and are large weights in benchmarks – the feel good stocks. I’ve always said I know exactly what stocks to buy to immediately improve near-term performance. Playing along is easy. Investing differently is not.

Investing to fit in with the crowd may feel good and it may be good for business in the near-term, but fads are cyclical and often end in embarrassment (google parachute pants and click on images). Participants in fads and manias often walk away asking “What was I thinking?”. But for now owning what’s working is working, so let the good times roll. I’ll stick with a more difficult position. Just like I did with the miners, until it pays off, I plan to stay committed to my new most painful contrarian position – 100% patience.

GDP and Gundlach

Given yesterday’s long post, we’ll wrap up the week with a short one. Two interesting topics I wanted to touch on today. First was this morning’s GDP report. According to the Commerce Department, GDP grew 1.2%, or half of what was expected. In effect, the U.S. economy lost at the earnings estimate game. Did its stock get destroyed? Not at all. The dollar was down slightly against the euro, but nothing spectacular. The yen’s movement didn’t count as it was distorted by the Bank of Japan’s “less than expected” decision on stimulus. The S&P 500 yawned at the weak GDP data and actually closed up.

Normally I don’t pay a lot of attention to macro data like GDP. As readers know, I prefer building a picture of the economy from the bottom-up. While GDP came in well below estimates, this shouldn’t be surprising for those of us (or readers of this blog) that have been monitoring the economy through actual business results. As I’ve attempted to illustrate over this earnings season, economic activity is not robust, with earnings in decline and revenues stagnant. Even the stronger reports haven’t been that impressive from a revenue and volume perspective.

If the Fed is data dependent, it’s not going to get much help from this number, even if there were bright spots. While the report showed household consumption grew an impressive 4.2% during the quarter, I’m skeptical. It doesn’t agree with what I’m seeing with the consumer companies I follow. I suspect this number will be revised down or was simply a rebound from a weak Q1 when household consumption was only 1.6% (seasonal adjustments may have influenced Q1 and Q2). Averaging Q1 and Q2 GDP would suggest a 1% growth rate, which is similar to what I’m seeing from businesses’ (organic revenue growth), so for what it’s worth, on total GDP I’m in agreement with the Commerce Department.

The last time the Fed had “data dependent” cover to raise rates was Q2 and Q3 of 2014. I remember those quarters were strong as I documented it in my quarterly letters. I was open-minded to the possibility the profit cycle was catching a second wind. In hindsight, those strong quarters were most likely due to a very cold winter or a seasonal rebound. Nonetheless, the Fed could have raised rates then, at least off emergency levels. Given what I’m seeing this earnings season, I don’t see how the Fed can raise rates in the near future. I don’t think rates should be where they are, but given the Fed’s data dependent stance, organic growth is simply not there for most companies or the economy. Today’s GDP report confirmed.

The second topic I wanted to discuss was an article a friend sent me today. The article was from Bloomberg, but the source was Reuters. In the article there was a quote from Jeffery Gundlach that supports my rational for going to 100% cash and recommending returning capital to clients. Mr. Gundlach said, “The artist Christopher Wool has a word painting, ‘Sell the house, sell the car, sell the kids.’ That’s exactly how I feel – sell everything. Nothing here looks good”.

Nothing here looks good — I love this quote and obviously couldn’t agree more. For what it’s worth, I actually did sell the house during the housing bubble. And during the current bubble, I actually did sell the car (I swapped into a much more dependable and affordable Toyota). I’m not selling the kids, but since I’m now unemployed, maybe I’ll sell their 529 plans. Just kidding kids!

Mr. Gundlach’s comments sound very familiar. The blog is going well. Is it possible the new Bond King is a reader? It must be frustrating being a bond manager in today’s environment. While I’m not holding my breath waiting for Mr. Gundlach to return over $100 billion in capital to his clients, it’s refreshing to hear another manager speak out against today’s “Opportunity Set From Hell” (see post below). I wonder how many other managers feel the same way. I suspect there is a lot of them, but unfortunately I don’t expect other managers to be as open about their beliefs. Bashing the asset class you’re attempting to sell can be bad for business.

Opportunity Set From Hell





After reviewing numerous quarterly reports and conference calls, it’s becoming clearer to me that the industrial economy remains in a recession. Consumer businesses are doing better relatively, but in my opinion, their results are not as strong as some of earnings game “winners” suggest. Today I reviewed the quarterly results of four consumer companies – two earnings game winners and two losers. The two earnings game winners were moderate to higher-end consumer companies that are more likely to benefit from record high stock prices. While the two losers have a consumer base with limited exposure to asset inflation.

One of the losers is a restaurant everyone knows and most likely has reviewed, McDonald’s. Normally I don’t spend a lot of time on large cap stocks, but their earnings release caught my attention. They lost the earnings estimate game by reporting $1.25 per share vs. expectations of $1.39 per share. In my opinion, the more important operating measurement was U.S. comparable sales, which only increased 1.8%. Management blamed lower than expected sales results on softening industry trends. But what really caught my attention was discussed on the conference call. Management noted, “In the US, second-quarter pricing year over year was up about 3%, compared with food away from home inflation of 2.6%.” With pricing up 3% and comps 1.8%, one can infer that traffic trends were negative.

McDonald’s customers are not exactly “loving it” in today’s economic environment. McDonald’s operating results are a good example of what happens when price increases meet stagnant wages. It’s also a good example of the disconnect between what I read on conference regarding price increases, or inflation, and what we’re constantly told by the Federal Reserve – that inflation is too low. I’m not seeing it Janet. McDonald’s quarter does not shout deflation, but instead it’s what I’d expect to see during periods of stagflation.

Management touched on industry conditions and the economy after an analyst commented on the “huge deceleration” within the restaurant industry. On the industry slowdown management said, “…well clearly — it’s been fairly well documented on the consumer slowdown across most consumer segments, to be honest with you, through this second quarter.” On the economy management noted, “I think generally there’s just a broader level of uncertainty in consumers’ minds at the moment, both trying to gauge their financial security going forward, whether through elections or through global events. People are certainly mindful of an unsettled world. And when people are uncertain, when families are uncertain, caution starts to prevail and they start to hold back on spend.” Pretty generic comments, but I thought it was noteworthy nonetheless. I’m a little skeptical of the election uncertainty excuse. It’s been used frequently this quarter. Does Trump or Clinton really impact your decision to order a Big Mac?

After reading McDonald’s conference call I wanted to read some good news, so I picked up Panera’s quarterly earnings report. Scrolling through the headlines I noticed Jim Cramer called it a blowout quarter, so I enthusiastically began to learn more. Panera won the earnings game by reporting $1.78 vs. its $1.75 estimate. The same-store comps I read in the headlines were an impressive +4.2%. However, after reading further, I discovered those comps were for company-owned stores alone. Franchise-operated same-store comps only increased 0.6%. Combined, system-wide same-store comps were up +2.3%, far from the blowout quarter Mr. Cramer claimed. And here’s the kicker when it comes to the company-owned comps of +4.2%. The growth came from transaction growth of only 0.4%, while average check growth was 3.8%. While slightly positive (a little better than MCD), traffic growth was weak as most of the comp growth came from price increases.

If inflation associated with dining out is running between 3-4%, it’s not surprising traffic growth is struggling at McDonald’s and Panera. Is the restaurant industry’s weak traffic trends in Q2 inflation related? After eating out for lunch and dinner today (I’m on the road again) and paying through the nose for mediocre fare, I think it’s highly likely! In fact after dinner tonight, I stopped by the grocery store and bought a less expensive and healthier option for lunch tomorrow.

Rent-A-Center was another consumer stock loser, as it missed earnings estimates considerably. Earnings per share were $0.19 vs. $0.43 and sales declined -8.1%. Same store comps were -4.9%. No way to spin this one pretty and management didn’t try. Poor results were attributed to issues with its point of sales system, weakness in oil markets (Texas 10% of sales), the reset of its smart phone category, and declining computer and tablet sales. Management was extremely disappointed. Investors were as well, driving its stock down 18%. In my opinion, Rent-A-Center’s customer base remains under stress and I’m not expecting an immediate turnaround.

For companies with aggressive buyback programs and above average dividends, please take note. Rent-A-Center bought back $200 million of stock in 2013 at much higher prices. Also, between 2013 and 2015 it paid out approximately $150 million in dividends. During this period it took on debt to help fund these shareholder friendly initiatives. It’s always tempting to reward shareholders when times are good, but sometimes it’s better to shore up the balance sheet for a rainy day. That day is now for Rent-A-Center. With $636 million in net debt, I’m sure they’d like to have some of that cash back.

Lastly, we’ll end with an earnings game winner, Tempur Sealy International, Inc. (TPX). Tempur Sealy squashed earnings estimates as it reported $0.92 vs. the $0.68 estimate. However, GAAP EPS was less impressive at $0.35 vs. $0.34. To understand the difference between the adjusted non-GAAP and GAAP earnings all one needs to do is comb through the 18 footnotes at the end of their earnings report. I did. One thing that stood out was $4.2 million in annual meeting costs in 2015. Nice. I’d like to have attended that one!

Temper Sealy adjusted non-GAAP earnings benefited significantly from higher adjusted gross margins of 40%. Margins improved due to operational improvements, pricing and mix. There’s that “pricing” comment again. If we’re having all of this deflation, why are there so many comments related to higher pricing on conference calls? By the way, Astec Industries, which we discussed yesterday, noted on their call that they are watching rising steel prices closely (more price increases). In any event, back to Temper Sealy. How much of their growth was pricing and mix? While sales were up 5.2%, management noted units sold only increased +2%.

Despite the slow unit growth, investors apparently loved the quarter and drove Tempur Sealy’s stock up 17%. I would have expected stronger organic growth given the stock’s large jump. Even Tempur’s management tempered (sorry) their enthusiasm by providing low single-digit sales growth guidance for the year. Management noted the worldwide economy is doing “just o.k.” and they pointed to some headwinds such as the election, international events, and currency. Management described the economy as having a 1.5% to 2% GDP feel. However, their best description of the economy was, “feels good, feels weak, feels good, feels weak”. That’s more accurate and clear than most economists!

In conclusion, a mixed earnings picture from four consumer companies. I found comments on pricing, traffic, and unit sales very interesting. The moral of the story is you can raise prices if your customers are benefiting from asset inflation and can afford to pay a 40% gross margin on a $5,000 mattress. However, if your customers’ spending decisions are largely dependent on fixed wages, raising prices may backfire and turn customer traffic or units sold negative.

Lastly, given the sharp rise in stock prices, I was surprised by the actual top line results of the companies that won the earnings estimate game. In my opinion, revenue growth did not appear overwhelming, especially after pulling out the effect of price increases. So goes the earnings estimate game, where actual results and real data points take a back seat to the “achievement” of jumping over spoon-fed earnings estimates.

New Roads and Bridges Beat New Countertops

I’ve been doing a lot of driving over the past couple of weeks. Two things I’m certain of: 1) there is a lot of road construction; and 2) I’m not going long corn as this year’s crop looks very healthy! The first point (a lot of road construction) is good news for Astec Industries, Inc. (ASTE), a market leading manufacturer of road building equipment. Founded in 1972, Astec’s products are used in each phase of road building.

While earnings season so far has been mixed to soft, Astec’s quarter stood out and showed strong growth. Sales increased 10% and EPS increased 55% to $0.79. Backlog improved considerably as well, up 59% to $365 million. Astec is benefiting from the passage of the 5-year $305 billion Federal Highway Bill that was signed by President Obama in December 2015. The passage of the highway bill provides some certainty for Astec’s customers and should benefit Astec’s operating results over the next few years.

The last time Astec’s customers had this type of visibility was after President Bush signed the Safe Accountable, Flexible and Efficient Transportation Equity Act in 2005, which authorized $286.5 billion in funding for federal highway and transit programs through September 30, 2009. Astec’s business performed well during this period as earnings per share (EPS) grew from $1.34 in 2005 to $2.80 in 2008. The program ended in 2009 and was replaced by month to month appropriations. Astec’s business suffered considerably once government funding certainty was replaced with uncertainty – EPS fell to $0.14 in 2009. Astec’s stock collapsed from its high of $57 in 2007 to $22 at its low in 2009.

In the current earnings environment of slow to negative growth, investors are willing to pay a very high price for above average growth and certainty. As investors stampede into anything with growth, Astec’s stock has benefited and is up 58% to $61 (all-time high) over the past year. The sharp increase in its stock price has driven Astec’s P/E ratio to 40x. At such an expensive valuation, investors are most likely valuing Astec based on its future earnings estimates. As earnings continue to increase, EPS could reach mid $2’s later this year and low $3’s later next year. I believe these earnings expectations are reasonable and are not too different from its last earnings cycle peak of $2.80/share.

In addition to being an example of investors’ eagerness to pay a high price for growth and certainty, I believe Astec is a good example of the growing use of peak earnings to value businesses. In Astec’s case, investors are valuing the business not only on peak earnings, but on peak earnings that have yet to occur (an even more aggressive valuation technique).

Although I believe Astec will generate healthy earnings growth over the next two years, a lot of this growth is cyclical, or growth coming off depressed earnings. In my opinion, given Astec’s valuation, investors are valuing the business as if recent growth is sustainable, not cyclical. The fact of the matter is Astec is a cyclical business. There’s nothing wrong with this, but extrapolating cyclical growth and valuing it as sustainable growth is another one of my top ten investment commandments – Thou Shalt Not Extrapolate Cyclical Earnings Growth.

Uncertainty and volatility in government funding is one of the reasons Astec’s business is cyclical. A large portion of Astec’s business is tied to government spending and is reliant on politicians coming to an agreement. Although funding can become tight during economic downturns, I believe during the next recession politicians will agree on providing fiscal stimulus. Furthermore, to fund the stimulus, I believe both parties will prefer the voter-friendly option of printing money, versus the more difficult decision of raising taxes or cutting spending. Therefore, I wouldn’t be surprised if helicopter monetary policy comes to the U.S. during the next recession – directly funding aggressive fiscal spending with monetary policy/money printing.

Unlike Japan, which may simply print money and hand out checks, I believe if helicopter drops come to the U.S. the majority of it will be project-based, such as spending on public projects such as improving roads and bridges. While I don’t agree with policy solutions that rely on getting something for nothing (money printing), I suppose a government induced bubble in infrastructure is better than what we received during the last cycle of malinvestment. After the housing/mortgage bubble popped, we weren’t left with much except for trillions of bad debt and millions of new granite countertops!

If helicopter drops are used for infrastructure and investment I suspect companies like Astec will benefit. Unfortunately, in my opinion, potential benefits have been priced in Astec’s shares, especially if using normalized earnings for valuation purposes, not future peak earnings.

Pizza! Pizza!

I rarely watch CNBC. That wasn’t always the case. I watched it in the early 90s when Neil Cavuto was the network’s rising star. He was very good and had some interesting guests. Things have changed a lot since then. Of course Neil is no longer with CNBC and the guests are, well, let’s just say a lot of them are a little too promotional for me. When I do watch CNBC it’s usually in a common area, like a gym. Today was one of those days as I watched from a treadmill.

The segment I was watching started by saying stocks were trading at 25x earnings. I thought, “Wow, they must be using GAAP earnings, not adjusted non-GAAP.” And they were, which immediately got my attention and increased my respect for the host and the network (even better if they used GAAP cyclically adjusted P/E, but I’ll take what I can get). Had something changed while I was away? Unfortunately nothing has changed. It was just a teaser before the good stuff began.

The host went on to say while stocks look expensive based on GAAP earnings, if you look at it from projected (non-GAAP) earnings, stocks are “only” trading at 17x earnings. The host then opined that above average valuations may be irrelevant given low bond yields. This was the setup before turning to the guest. As 9 out of 10 portfolio managers that appear on CNBC do (I have no data supporting this), the guest began to tell investors that there is no alternative (T.I.N.A.) to stocks. I immediately grabbed the remote and searched frantically for Bloomberg TV, which isn’t much better, but I like their scrolling headlines.

Is this the best the investment management industry has to offer? There is no alternative? And I thought “The New Economy” rational in 1999 was looney. Will T.I.N.A. be in the new fiduciary duty rules? Always act as a fiduciary…unless of course there’s no alternative, then do whatever you want with other peoples’ money. In my opinion, T.I.N.A. is just one more excuse, or easy to understand one-liner, to help sell and justify overpaying near the peak of a cycle. There may not be an alternative for central banks (to keep the game going) and relative return investors (to keep playing the game), but absolute return investors have a choice.

The logic behind T.I.N.A. goes like this. Because rates are so low and are expected to stay low indefinitely (so they say), it’s acceptable to alter valuation variables to make stocks appear more attractive. A high quality stock is essentially a perpetual bond with a variable coupon. How you value a perpetual bond is simple. It’s cash flow divided by discount rate (CF/k). Forgive me if this is review for many of you, but we have a few readers who majored in psychology (they probably tend to be better investors than finance majors).

Let’s assume you have $100 in annual cash flow and you demand 10% return on investment. Let’s also assume the cash flow is stable indefinitely. In this case, the value of this perpetual stream of cash flow is $1,000. With interest rates so low, the theory is an investor should reduce the discount rate, or required rate of return. If the investor lowers the required rate of return to 5% from 10%, the value of the same stream of cash flow jumps to from $1,000 to $2,000. This is what has happened to stocks this cycle. We’ve had huge multiple expansion, which is another way of saying investors are requiring less return to assume the same risk. They are doing this because apparently “they have no alternative”.

Here’s the problem with lowering investment standards, and in this case, lowering the required rate of return assumption. When valuing risk assets, the discount rate is used to measure risk or the uncertainty of an investment’s future cash flow. As I illustrated in previous posts, risks to company cash flows are alive and well. After Q2 we’ll have had five consecutive quarters of negative earnings growth. If risks to cash flows haven’t been reduced, why should an investor demand a lower return on investment? Businesses are not risk-free and shouldn’t be valued as such. Furthermore, I don’t believe artificially suppressed risk-free rates should be the starting point or foundation of a business valuation.

To think about this in simple terms, pretend you own a pizza shop (during asset bubbles I often imagine making pizzas instead of fighting the Fed). You buy the pizza shop for $200,000 and it generates $50,000 a year in cash flow. So you’re receiving a 25% return on your investment assuming cash flows remain stable. But stable cash flows is a dangerous assumption when running a business and that’s why you’re requiring a much higher return on capital than a risk-free rate (also known as a risk premium). Do you care about risk-free interest rates? Maybe if you borrowed to buy the pizza shop or if your lease is tied to interest rates in some way, but for the most part you’re much more concerned about operating risks.

Cheese prices are volatile and a major cost. Minimum wage is increasing. Oh no, the health inspector just shut you down for a week. Papa John’s and Little Caesars are both opening next door – pizza price wars! Pizza ovens burn a lot of natural gas. Your delivery guy just ran over a $5,000 poodle. Your building was just bought by a private equity firm that overpaid and they are raising your rent 20%. The kid running the cash register is missing and so is the cash. All of a sudden the positive $50,000 cash flow you were valuing is now negative -$50,000. Is your business still worth $200,000?

In effect, are risk-free rates relevant to your pizza shop valuation? I don’t think so. In my opinion, operating risks of a business are the most important risks to cash flows and it is the risk to cash flows that should determine an investor’s required rate of return, not risk-free rates. I prefer using a required rate of return that consists of what I’d lend to a business and then apply an equity risk premium on top of that (combined it’s typically 10-15% discount rate). Granted this valuation technique remains subjective, but it makes much more sense to me.

For those who continue to insist the risk-free rate should be the foundation of business valuation (academic version and often used by those with perfect SAT scores), the math still doesn’t work. If one were to use a low discount rate based on low risk-free rates, they must also assume risk-free rates stay depressed indefinitely. If we assume interest rates stay depressed indefinitely, shouldn’t we also assume growth rates remain depressed? Isn’t subpar growth in domestic and global economies the reason risk-free rates are low? You can’t have it both ways — if you use a lower required rate of return due to abnormally low risk-free rates, you can’t also assume normal growth rates. In theory, the lower growth rate would offset the valuation benefit from the lower discount rate (CF/k-g).

We’ll get back to actual businesses and operating results tomorrow, but I thought it was important to touch on why lowering valuation standards doesn’t make sense to me. I believe T.I.N.A. is just another end of the cycle excuse to overpay, or one more version of this time is different. When has lowering your standards ever worked in life? Why do it with your money, or even worse, someone else’s money. No more CNBC for me! However, a pizza sounds good.

What’s the Deal With Japan? (Seinfeld tone)

A friend of mine just emailed me a headline “BOJ Officials Said to Be Leaning More Toward Easing”. The helicopter money drops are coming — get out your fishing nets!

Here’s what I don’t understand about Japan. They’re scared to death of deflation, but it’s one of the most expensive places in the world to live. How does that make sense? In 2013, CNN Money ranked Tokyo and Osaka, Japan as the two most expensive cities in the world. Does Japan really need higher prices to prosper or are they looking for a free ride (fund unmanageable debt with unimaginable monetary policy)?