For Wage Inflation Press 1

I enrolled in graduate school during the tech bubble. With the Nasdaq up over 80% in 1999 and the portfolio I was managing down -8%, my career in investing appeared to be over. As such, I thought I might as well go back to school and try to figure out what I was going to do next. As luck would have it, shortly after I enrolled, the tech bubble popped and I kept my job! I wasn’t thrilled about going back to school while working, but in hindsight I’m thankful Greenspan’s “New Economy” forced me into getting my MBA.

While I had some very good classes, one of the things I remember most was all of the new terminology I acquired. Some examples include: mission critical, thought leader, paradigm shift, scalability, footprint, SWOT, and [insert anything] followed by solutions. It’s all about those solutions!

Although “sound smart” business terminology isn’t very useful in investing, it can be helpful when translating business lingo. For example, Sykes Enterprises (SYKE) is a market leading provider of comprehensive customer contract management solutions in the business process outsourcing industry. Sounds impressive, but what in the world do they do? MBA translation: operator of call centers.

Sykes is on my possible buy list, along with its competitor Convergys (CVG). The call center industry is a pretty boring business, but the market leaders can generate attractive free cash flow. Operating margins average around 8-10%. Margins fluctuate with capacity utilization and changes to client programs (new products, marketing, decision to take call centers in-house or outsource, etc). Industry growth is similar to nominal GDP (around 3%). The market leaders have benefited from their clients’ desire to consolidate service providers. Automation and technology present risks and opportunities. In my opinion, the call centers are not great, but good businesses (assuming you’re a market leader).

I’ve owned Sykes and Convergys in the past. With the stock of Convergys in decline and becoming more attractively priced, I’m currently getting up to speed on both companies. As I worked on their businesses this week, I bumped into something I’m noticing more frequently in recent earnings reports and conference calls – inflation. Specifically, Sykes and Convergys both mentioned growing wage pressures within their industry.

Sykes did a particularly good job of explaining rising labor costs on their conference call. Their CEO, Charles (Chuck) Sykes, has historically gone out of his way to help investors understand the industry and operating environment. His commentary is usually long, but often very worthwhile. I selected and highlighted several of his comments related to labor costs.

Sykes is noticing wage inflation in local markets and is having to spend more to engage employees.

“Given the headline improvement in employment trends in the US, where the unemployment rate has been hovering around 4.8%, there is some concern about limited slack in the labor market and wage pressures, although there have been pockets of labor tightness in some cities and states, the broader picture across the markets in which we operate remains manageable. Still with labor slack dictated more by local market conditions, we are having to employ monetary and non-monetary levers to optimize employee engagement. Specifically we are adjusting strategies and tactics around talent management with a focus on improving attrition and absenteeism.”

Wage inflation remains manageable, but if it tightens further, more will need to be done.

“All told, the supply of labor doesn’t appear to have reached that tipping point where it is impacting our long-term margin targets but if the economy picks up steam rapidly and as a broad spectrum of industries use wages to access labor markets, we will have to work with our clients to help them evaluate the best trade-offs between wage and price against our service strategies.

Discovering and monitoring wage inflation is a process – there’s not an immediate notification.

“To answer your question, you know, it took us a little bit to really start suspecting things around the wages. I mean normally, and I think this is probably true for most anyone in our industry, you know, the symptoms are looking at your application rates. You know, a number of people that are showing up at your door to want to get a job and you start looking at your recruiting or once you hire the folks, a number of people that show up or once they show up, the number of people that, you know, what the absenteeism rate is and then once times going on, you know what that attrition level is. These are normal drivers that have been around for many, many years but normally when you start suffering in one of those, candidly I would say most of the time it’s kind of operationally driven.”

Initially management thought labor pressures were a result of normal fluctuations in business activity, but eventually concluded it may be something more.

“But once we worked on this for a while during the ramps and we just weren’t moving the needles enough and then just all the commentary that we’re all reading in the papers about minimum wage pressures. Keep in mind now, you know, we’ve had 22 states in our country that have raised minimum wage. You know, as we look at those things, those are things that we’re starting to avalanche our head and say I think maybe we’ve got some challenges here on the wage side.

Sykes is early in the process of addressing labor challenges, but they plan to move ahead – other clients and industries have already announced wage increases.

“Again, what’s encouraging is I believe this is something that in the beginning it’s going to be a little tight because I don’t know if our competitors are all moving at the same time that we are. I would say probably not. That’s going to create a bit of unevenness, if you will, and maybe when you’re chatting with other colleagues of ours, our competitors, how they speak about it. But I do think we are starting to see, we’ve already seen some of our big clients, particularly in banking industries, they on their own have announced wage increases. I believe it’s real and I believe the industry will adjust.

How quickly the labor cost trend increases remains uncertain.

“The challenging news is I just don’t know how fast. And again for our group of customers and conversations we’re having, we’re anticipating more of the second half of the year to get some of those things resolved. It’s a long answer to your question but it’s a complicated thing in just trying to give total context to it.”

Thank you Sykes for the very informative and productive discussion on labor inflation. As the Federal Reserve debates whether to raise the fed funds rate 25 basis points to 0.75%, the real world isn’t waiting around to respond to the changing price and cost environment. For Fed members voicing their concerns about falling behind the inflation curve, it might be time to call their favorite customer service center and start measuring wait times! Your call is very important to us…

Have a great weekend!

Strong Buy: Nike Men’s 11 ½

A college friend of mine has an incredible memory. While in college, instead of using his talent to make stellar grades, he memorized movie scenes, comedian acts, and whatever else he found entertaining. In addition to having a great memory, he was, and still is, very good at delivering what he memorizes – it’s often better than the real show!

I recently had lunch with my friend. It’s always an enjoyable and easy lunch. All you need to do is sit back and wait for him to start entertaining. During our last lunch, he asked if I’ve ever seen the comedian Louis CK perform. “I have not,” I said. He seemed to be excited. “Oh, he’s great, you’re going to love this.” He immediately started into his Louis CK performance.

The short and clean version (profanity-filled version google Louis CK Bill Gates):

“I was reading about Bill Gates…he has like $85 billion.”

“Do you know what you could do with $85 billion? You could buy every baseball team and make them wear dresses, for like $3 billion and still have $82 billion…how do you not do that!? I would do s&%# like that every day.”

“One day I’d go out and buy all the pants in the world and just burn them. #*&% everybody. No more pants. Start over with making pants. They’re all gone.”

As my friend continued with his show, my mind unexpectedly shifted to the consumer. Louis CK’s idea of buying all of the pants reminded me of Kohl’s (KSS) recent quarterly report and its vanishing inventory. Kohl’s recently announced quarterly same-store comps of -2.2%. Comps probably would have been worse without a 3.7% increase in average price at retail. Transactions per store declined a whopping -6%.

In a sluggish consumer environment with declining traffic, retailers and restaurants seem to be taking two very different approaches. They’re either discounting in an attempt to improve traffic, or increasing price and reducing promotions to protect margins. Kohl’s appears to be protecting margins. This can be seen in their gross margins and inventory. Despite declining same-store comps, gross margins increased 33 basis points during the quarter as they “improved both permanent and promotional markdowns.” Management also noted inventories by year-end declined 5% in dollars and 7% in units (disappearing pants!).

What do lower promotions and lower inventory mean for consumers? Higher prices of course. Increasing signs of inflation is a theme I’ve noticed over the past few months and a trend I continue to monitor closely. Even the government seems to be picking up on higher prices. Today the Commerce Department reported the personal consumption expenditure price index rose 0.4% in January and is now up 1.9% year over year. With the fed funds rate remaining well below the rate of inflation, it’s rational to question the Federal Reserve’s commitment to containing the recent uptick in consumer prices.

With the Federal Reserve falling behind the curve, how can consumers protect themselves from the rising cost of living? If hard assets aren’t your thing, what about taking advice from Louis CK and “buying all of the pants”? The concept of making money from inventory isn’t new. For example, Core-Mark (distributor to convenience stores) often reports gains on its inventory of cigarettes as manufacturers consistently raise prices. The consumer can replicate this strategy by buying pants, shoes (Foot Locker recently reported higher average selling prices), or whatever else in their life is going up in price.

My latest investment idea is to corner the market of men’s size 11.5 running shoes (my size). It’s my hedge against rising consumer inflation, possible trade wars, and import taxes. I’ll make a killing assuming retailers continue to reduce inventory and the world’s largest shoe producing nations say, “No more shoes. Start over with making shoes. They’re all gone.”

You know stocks are expensive when comedians become your best idea generators. How appropriate!

Buffett 1999 vs. Buffett 2017

This may sound awful coming from a value investor, but I don’t read Berkshire Hathaway’s annual reports cover to cover. I did earlier in my career. In fact, I’d eagerly await its release, just as many investors do today. However, over the years I’ve gravitated more to what makes sense to me and have relied less on the guidance from investment oracles such as Warren Buffett (see post What’s Important to You?).

While I know significantly less about Warren Buffett than most dedicated value investors, it seems to me that he has changed over the years. I suppose this shouldn’t be surprising as we all have our seasons. And maybe I’m the one who has changed, I really don’t know. But I remember a different tone from Buffett almost twenty years ago when stocks were also breaking record highs. It was during the tech bubble when he went out of his way to warn investors of market risk and overvaluation.

I found an old article from BBC News with several Buffett quotes during that period (link). The article discusses Warren Buffett’s response to a Paine Webber-Gallup survey conducted in December 1999. The survey showed that investors expected stocks to rise 19% annually over the next decade. Clearly investors were extrapolating recent returns far into the future. Fortunately, Warren Buffett was there to save the day and help euphoric investors return to their senses.

The article states, “Mr Buffett warned that the outsized returns experienced by technology investors during 1998 and 1999 had dulled them into complacency.”

“After a heady experience of that kind,” he said, “normally sensible people drift into behaviour akin to that of Cinderella at the ball.

“They know that overstaying the festivities…will eventually bring on pumpkins and mice.”

I really like and can relate to the Warren Buffett of nearly twenty years ago. If I could go back in time and show the 1999 Buffett today’s market, I wonder what he would say. I’d ask him if investor psychology and the current market cycle appears much different than the late 90s.

Similar to 1999, have investors experienced outsized returns this cycle? From its lows in 2009, the S&P 500 has increased 270%, or 17.9% annually. This is very close to the annual returns investors were expecting in the 1999 survey, when Buffett was warning investors.

Have investors been dulled into complacency? Volatility remains near record lows, with every small decline being saved by central banks and dip buyers. Investors show little fear of losing money.

Are today’s investors not Cinderella at the ball overstaying the festivities? It’s the second longest and one of the most expensive bull markets in history!

There are of course differences between 1999 and today’s cycle. While valuation measures are elevated, today’s asset inflation is much broader than in 1999. The tech bubble was extremely overvalued, but narrow. A disciplined investor could not only avoid losses in the 1999 bubble, but due to value in other areas of the market, could make money when it burst. Given the broadness of overvaluation in 2017, I don’t believe that will be possible this cycle. In my opinion, it will be much more challenging to navigate through the current cycle’s ultimate conclusion than the 1999 cycle.

The broadness in overvaluation this cycle makes Buffett’s recommendation to buy a broadly diversified index fund even more difficult for me to understand. Furthermore, given the nosebleed valuations of many high quality businesses, I’m not as confident as Buffett in buying and holding quality stocks at current prices. It again reminds me of the late 90s. At that time, there were many high quality companies that were so overvalued it took years and years for their Es catch up to their Ps. But these are important (and long) topics for another day.

Let’s get back to Buffett 1999. I find it interesting to compare him to Buffett 2017. Surprisingly, Buffett 2017 doesn’t seem nearly as concerned about valuations this cycle. Buffett writes, “American business — and consequently a basket of stocks — is virtually certain to be worth far more in the years ahead [emphasis mine]. Innovation, productivity gains, entrepreneurial spirit and an abundance of capital will see to that. Ever-present naysayers may prosper by marketing their gloomy forecasts. But heaven help them if they act on the nonsense they peddle.”

You can include me as a naysayer of current prices and valuations of most risk assets I analyze. Based on the valuations of my opportunity set, I’ll take the advice from another naysayer – the Warren Buffett of 1999. As he recommended, I plan to avoid extrapolating outsized returns and will not ignore signs of investor complacency. I plan to remain committed to my process and discipline. By doing so, when the current market cycle concludes, I hope to achieve two of my favorite Warren Buffett rules of successful investing – avoid losing money and profit from folly.


Bubble Watching

I always get a kick out of central bankers and market strategists who state they don’t see signs of market froth. How can that be? During periods of overvaluation, it can be seen clearly in prices, valuations, and yields. It can also been seen all around us in everyday life.

This morning I drove my son to school and took the scenic route along Ponte Vedra Blvd. It’s a very nice five mile drive along the ocean. The entire drive is littered with new homes or new homes under construction. These are very nice and very big homes that are being built where very nice and very big homes once stood. I call it the teardown bubble. Although driving through the teardown bubble is challenging given the number of dumpsters and construction trucks, it’s a worthwhile drive if you enjoy bubble watching (a hobby of mine).

During the last credit and market cycle, condos were sprouting up everywhere near the beach. This cycle is different as it’s more high-end homes versus condos. It appears the 1%’ers are trading in some of their gains on financial assets to raze the old and build the new. I suggest the Federal Reserve rent a tour bus and take a drive down Ponte Vedra Blvd before their next Fed meeting. After the tour, I suspect they’ll have trouble arguing their policies have not created excesses, imbalances, and inequality. At the very least, they will no longer be able to say they haven’t seen signs of market froth.

Shortly after I returned from my drive through Asset Inflation Boulevard, I came home and turned on the television. On the screen was a city’s skyline filled with construction cranes. At first I thought it was Nashville, or the Dubai of the South (thanks to a reader for the perfect description). But no, it wasn’t Nashville, it was London. Whether it’s Nashville, London, or Ponte Vedra Blvd, in areas populated with beneficiaries of asset inflation and credit growth, you will find significant levels of construction activity, and yes, construction cranes (a historically reliable sign of cycle froth).

Signs of this cycle’s excesses are obvious, in my opinion. For investors fully committed to the current cycle, these signs are either invisible or believed to be sustainable. I’ll admit, the duration and durability of this cycle has been impressive. And with help from the “unlimited” global central bank bid, maybe it can last longer. I really don’t know, but I do believe signs of froth are clear. Similar to past cycles, identifying these signs has been beneficial in avoiding unnecessary losses when the boom inevitably turns to bust. 

Picture of London below. Out of curiosity, I placed it above a picture of Nashville’s skyline to compare. It’s fun to play count the cranes!

Have a great weekend!


Consumer Update

After the Fed’s minutes were released yesterday a friend emailed, “I guess when rates [long bonds] are at 2-3% it’s difficult to admit inflation could be a problem.” I responded, “Let’s see…would the Fed rather have an inflation problem or the stock market decline 50%? Inflation problem hands down. I believe they’ll act accordingly.”

While you’ll never read about it in the Fed minutes, I suspect there is an ongoing discussion within the Federal Reserve regarding asset inflation and why it isn’t “properly” spilling over into the economy. Why has the economy been stuck in 1-2% growth with asset prices reaching record highs? Is Dow 20,000 not stimulative enough? What heights do asset prices need to reach to generate 3-4% nominal growth? Do we need Dow 50,000? $1 million 1800 sq/ft homes? What’s the magic number? And how can the Fed get to the magic number while it’s considering tightening monetary policy?

In my opinion, the Fed wants to raise rates, but is overly concerned about financial stability and an economy overly dependent on inflated asset prices. While this cycle’s asset inflation has been impressive, for the most part, it has only been sufficient to sustain last cycle’s excesses, not expand on them. Nonetheless, maintaining elevated asset prices remains an important policy tool as a bear market in risk assets would most likely send the economy into a recession.

The question isn’t if the Fed should raise rates, it’s can they raise rates while keeping asset prices inflated? That’s their challenge. Complicating matters further, it now appears the Fed has achieved its inflation target before the economy has reached “escape velocity”. It’s an interesting situation they’ve put themselves in. I’m looking forward to watching how this market, profit, and monetary cycle ends from the comfort of my patient positioning.

Enough talk about the Fed. It’s like thinking about what’s at the end of the universe – it will drive you nuts and it’s not very productive.

So what’s going on in the real economy? Fortunately several consumer companies reported operating results this week, providing us with some real-time data.

Wal-Mart’s (WMT) results made the news and caused the market and consumer stocks to rally. To be fair, what doesn’t cause stocks to rally these days? In any event, the market’s reaction increased my curiosity, so I checked it out.

Wal-Mart’s same-store comps increased 1.8% with a 1.4% increase in traffic. While not strong growth, I suppose in today’s retail environment positive traffic is a good sign. Adjusted earnings of $1.30 apparently beat estimates, but I failed to find last year’s EPS in their press release. However, I did find operating income, which declined 6.6%. Is Wal-Mart adopting the Amazon model of sacrificing profitability for sales? Growth is expected to be flat next year with earnings expectations of $4.20 to $4.40 versus $4.32. Same-store comps are also not expected to accelerate, with 1% to 1.5% comp growth expected next quarter. I don’t follow Wal-Mart closely, but their results and outlook don’t appear to signal much of a change in consumer behavior.

Home Depot (HD) was the other large retailer reporting this week. The company continues to perform better than most retailers considering its business is a major beneficiary of shelter inflation. Large ticket items continue to boost results with transactions over $900 increasing 11.6%. Total comps in the U.S. were up an impressive 6.3%. A little less impressive, but still respectable, was transaction growth of 2.8%. Average ticket increased 2.9%. Management noted average ticket “was slightly impacted by commodity price inflation and foreign currency.” The company is expecting same-store sales growth of 4.6% in 2017. Management’s sales guidance is based on a 2.3% GDP forecast.

An interesting data point from Home Depot’s conference call, “If you look at home equity, since 2011 home equity is up 108%. On average that equates to $50,000 per household. And we believe that is contributing, as people use the equity of their houses to spend back into their house we believe that’s contributing to our growth, so we factor that into our guidance, and that’s how we got to the 4.6%.” William Dudley (Fed member who recently discussed the wonders of home equity loans) should be happy!

Is management concerned about rising interest rates? Apparently not. “With a median home price in the country of $250,000, mortgage rates could go up to 7%-ish before the affordability index would fall at 100 or below. So there’s a way to go before we’d be concerned.”

Lumber Liquidators (LL) also reported results this week. Its stock soared 18% after the company announced same-store sales comps increased 2.8%. I was impressed until I discovered “traffic was down slightly” and average ticket increased 3%. Were investors celebrating operating results or inflation/mix? I don’t have a bone to pick with Lumber Liquidators, but an interesting comp/traffic data point nonetheless.

Texas Roadhouse (TXRH) saw its stock decline 12% yesterday after reporting slower than expected growth. The company reported same-store sales comps of 1.2% with traffic growth of 0.2%. Comps during the first 55 days of 2017 have increased 1.5%.

On costs, management noted, “…the impact of approximately 2.9% commodities deflation was offset by higher wage rate inflation and higher costs associated with payroll taxes, insurance reserve adjustments and gift card fees.” Similar to Ruth’s Chris, Texas Roadhouse benefited from lower beef costs. Labor costs are expected to remain an issue and management expects to address them with higher prices. Management noted, “We recently took some additional pricing in a few states where wage rates rose significantly.” The company expects mid-single digit labor inflation in 2017 (base wage rate up 4.5% in Q4).

Management commented on slowing trends stating, “I can tell you we would say we haven’t changed anything about the way we’re operating or doing business, so nothing that we could point to internally that would be changing those trends. I think there’s just a lot of noise right now between, like I said, between weather and some other stuff going on maybe on the macro side of things, just with the holiday shift and things like that. Outside of that, nothing that I can point to.” Management also commented on the industry saying, “Many of our competitors are struggling, for sure. We’ve seen a lot of tough sales reports announced recently from a lot of companies, and they have all taken certain amount of pricing actions relative to inflation, which especially on the labor side is getting tougher and tougher.”

And finally, I don’t follow America’s Car-Mart (CRMT) closely, but noticed their earnings release and found management’s comments regarding disappointing sales interesting. From their press release, “Our expectations were higher going into the quarter and some of the shortfall was most likely related to delays with income tax refunds this year. At the same time, we are certainly seeing some overall softness in the market after so many years of excess lending with significantly extended contract terms. Our customer base has been stuffed with offerings for several years now and we are feeling the negative effects of market conditions.”

Our credit losses were elevated for the quarter, as for the most part we saw increased losses broadly across the Company. Even though we came into the quarter with higher delinquencies, we did expect better credit results for the quarter.”

Again, I don’t follow their business closely, but remain on alert for signs that the current auto cycle may be losing steam.

In conclusion, based on recent earnings results and company outlooks, it does not appear consumer trends have changed noticeably. I’ll continue to monitor results and adjust my views if necessary.

Special Dividends

I have a confession to make. I don’t read many books related to investing. Early in my career, when I was developing my investment philosophy, I was constantly reading investment books. However, as my investment process and discipline matured, I discovered I learned more from reading about companies. And there is a lot to read. There are times after a long day of reading SEC filings, transcripts, and other company-specific related material, my brain lets me know it’s had enough. I call it mush-head. When it occurs varies, but when mush-head hits, I know it’s time to stop reading and do something active or just relax. Reading a book is the last thing my mind wants to do.

Although I rarely read investment books, there are exceptions. Thanks to a reader of this blog, I’ve been reading The Education of a Value Investor, by Guy Spier. It’s about a hedge fund manager and his journey to becoming a successful value investor. It’s easy to read and entertaining. In the early chapters, Mr. Spier discusses his challenges at his first job and his decision to resign. Shortly after his departure, Mr. Spier discovers Tony Robbins, and unexpectedly admires and learns from him. As I was reading about the wonders of Tony Robbins, a paragraph hit me like a ton of bricks.

Mr. Spier writes, “Robbins hammered into my head the idea that, if you want to go somewhere, anywhere, and you’re stuck, ‘Just Do It! Just make a move. Any move!’ This might seem obvious to many. Hell, it was obvious to me. But my bias toward analysis-paralysis meant that it was easier for me to pontificate in a library than to act.”

Just make a move. Any move. That really struck a chord with me. I immediately thought of my experience last year when I was sitting alone in my office making one of the most important decisions of my career.

I was in the process of wrapping up a very  difficult and contrarian position – the precious metal miners. Owning the miners was one of the most painful and lonely investment experiences I’ve ever endured. Possibly more painful than refusing to buy tech stocks in 1999. If you want to know what it feels like to be a contrarian, I suggest owning precious metal miners in a devastating and relentless bear market (many miners were down 80-90%). I’ve seen some hated stocks in my career, but nothing comes close to the hatred of the miners, absolutely nothing. If toxic waste went public, it would have traded at a premium to the miners in 2014-2015.

It was a long and painful road, but eventually the precious metal miners appreciated significantly in 2016 and approached my estimated fair value. As I began selling the miners, cash levels increased from an already high and uncomfortable level. While I was thrilled to be closing out a very challenging position, I was suddenly confronted with a new problem. The precious metal miners  were the portfolio’s largest position and the largest discounts to value. With their stocks rising sharply and their valuation gaps closing, I no longer had sufficient discounts in the portfolio. How could I generate attractive absolute returns in the future with 90% of the portfolio in cash yielding nothing and 10% in equities trading near fair value? I was stuck, and as Tony Robbins would advise, I needed to make a move.

I felt I had two options. I needed to either find a way to get invested or recommend returning capital to clients. After running numerous small cap screens and going through my possible buy list for the hundredth time, it became very clear to me, I was not going to be able to find a suffient number of attractively priced small cap stocks. It was at that time I made my move. A little over eight months ago I recommended returning capital to clients and stepped away from the asset management industry and my dream job of managing an absolute return portfolio.

Reaching a 90% cash position and recommending returning capital was never my plan. My plan was to manage the absolute return portfolio I had been running since 1998 until I was too old to remember my name. I had a personal goal of generating 50 years of attractive absolute returns for friends and clients. Although things didn’t go according to plan, I was still able to generate 18 years of attractive absolute returns (and relative returns if that floats your boat), successfully navigate through two epic asset bubbles, and pick up a couple Lipper Awards along the way (to be fair, if there was a Toilet Bowl Award, I probably would have won a few of those too – 1999, 2003, and 2013 come to mind!). Not too shabby I suppose, but an uninterrupted 50 years in the industry would have been quite an achievement.

I badly wanted to help friends and clients get through the third asset bubble in my career. However, as mentioned in past posts, today’s market cycle is very different than the bubbles of 1999 and 2007 – the overvaluation is so much broader. This cycle’s asset inflation has infected almost every asset class and stock I consider for purchase. As such, I believe my options are significantly limited. In my opinion, the best move at this stage of the market cycle remains being patient and flexible. In effect, it was my decision to move to 100% cash — for an extended period if necessary — that drove my decision to recommend returning capital and stepping away from the industry.

So how has stepping away worked out? So far Tony Robbins was right. Making a move, any move, was a good move. Although my decision to recommend returning capital was driven by overvaluation and my desire to go “all in” on patience, there were more important reasons and benefits that I was unaware of at the time. For example, I’ve been introduced to many like-minded investors I would not have met otherwise. My blog has turned into a support group of sorts. Being a contrarian and investing differently can be very lonely, especially during the later stages of a market cycle. It’s not now. The support has been tremendous and very much appreciated.

While once thought to be near extinction, I’ve been pleasantly surprised by how many absolute return investors continue to roam the investment landscape. There are even more of us than there appears, as there are a number of absolute return investors trapped in relative return mandates and organizations. In fact, if we polled all active asset managers, I suspect we would learn that many would prefer managing money in an absolute return manner. However, due to business and career risks, they are forced to tow the relative return line. I’m convinced absolute return investors are the silent majority of professional investing — silenced by the goal of retaining and growing AUM (assets under management).

Another benefit of taking time away from the industry includes a flexible schedule. I’m still performing the same tasks, but going about it differently. For example, instead of sitting behind a desk, I’ll often listen to conference calls while taking long walks. I’m also monitoring the markets and news less frequently, which has improved my focus and increased productivity. I exercise more. I’ve been working out, I’m huge (kidding…another joke for Seinfeld fans). I’m also meeting more people outside of the industry. While walking my dogs at lunch, I met an elderly woman who likes to tell dirty jokes. The first couple of jokes were uncomfortable, but now I look forward to them. They’re pretty clever and funny. I’ve discovered most people couldn’t care less about central banks and inflated asset markets – the diversity in thought and conversation has been refreshing. And last, but not least, I’ve reached “Gold Status” at Starbucks (includes free refills and a free drink on your birthday) – one of my finer achievements!

While I’ve benefited from getting out of the office routine, the greatest benefit, by far, has been the extra time I’ve been able to spend with my family. I know this sounds corny and overplayed, but it’s true. I can’t remember how many press releases I read over the years regarding management changes that stated, “CEO stepping down to spend more time with family.” I would roll my eyes and say, “Yeah, right, I wonder what went wrong.” I was the one who was wrong. I get it now. I didn’t get it when I was full throttle into my career. I was blind.

Although I felt like I was spending plenty of time with my family, looking back, I wasn’t always there. My mind was often still at work. And some of the time wasn’t quality time. Most weekends I’d bring the kids to the office so I could sneak in a little extra work. I’d put my son on my lap. He’d watch Thomas and Friends on the right screen and I’d have Bloomberg on the left screen. Whether at work or at home, I was constantly thinking about the markets, the economy, and the companies I follow. I didn’t realize how much work had taken over my life. I was an investment junkie.

Thank goodness for Bernanke and Yellen’s asset bubbles and their prohibition of investing (as I define it). Without their “temporary” 8-years and counting emergency monetary policies and all-inclusive asset inflation, I’d still be at my desk encompassed by my career with my blinders on.

I continue to plan to return to the investment management industry. I’m going to run a portfolio again and I’m looking forward to it. However, the time I’ve taken away has been invaluable. I’ve learned about the importance of being balanced and the risk of being overly submerged in one’s profession. I’ve also learned a lot about uncertainty – it’s not as scary as I thought. It’s been the exact opposite. Things seem clearer to me than ever.

If you feel stuck and you need to press the refresh button, making a move, any move, may be something to consider. Until you make the move, it’s easy to only see the risks and it’s difficult to see the potential benefits. But the benefits are there. They’re in front of you.

Saved by the Cow

Ruth’s Hospitality Group (RUTH) reported earnings this morning. The operator of Ruth’s Chris Steak House provided a good summary of many of the macro trends I documented during the most recent earnings season.

First, the consumer remains stubbornly sluggish. On their conference call management stated, “The pace of the consumer overall feels very much the same.” Company-owned stores reported flat same-store sales during Q4. Same-store comps were aided by higher average check growth of 2.3% (1.6% pricing). Traffic declined 2.2%. This is a subject I’ve addressed in recent posts. I believe a better measure of consumer demand is volume and traffic, not same-store comps that are often aided by mix and price. Comps excluding price and mix will be especially important to monitor in a more inflationary environment.

Another theme I’ve documented this quarter has been rising costs. Labor inflation was noticeable at Ruth’s Chris this quarter and year. Specifically, the company’s operating expenses as a percentage of sales increased 30 basis points, “primarily due to an increase in labor expense.” On their conference call, management stated they expect another year of fairly significant labor inflation with last year’s wage inflation increasing 4-5%.

There were some bright spots on expenses. Food and beverage costs declined 180 basis points, with beef costs declining 6.4%. As you can see from the chart below, the decline in beef prices appears to be over. Management also noted this deflationary benefit may be ending, stating certain steak cuts are up 6-9% year over year. That said, the company is expecting their overall commodity basked to be manageable next year.

Cattle Futures Chart

When determining normalized cash flows, it’s important to consider how fluctuating input costs influence profit margins. What is the company’s possible margin range and what costs influence that range? Similar to earnings, costs of a business have their own cycles. It’s important to know these cycles in order to properly determine a company’s normalized margins and cash flows. For example, I’d be reluctant to extrapolate Q4 beef costs when calculating Ruth’s normalized margins.

As a reminder, calculating accurate normalized margins is essential in developing an accurate business valuation.  Having a high degree of confidence in a business’s value is also essential to my absolute return process and discipline. Without valuation confidence, it’s difficult to act opportunistically and decisively – decision making becomes erratic and foundationless. Furthermore, accurate valuations can help limit mistakes and permanent loss to capital.

In conclusion, Ruth’s Chris’s profit margins have benefited from lower beef costs — a trend that appears to be reversing. Furthermore, earnings and same-store comps were aided by the company’s ability to raise prices. While same-store sales comps are important, I believe the quality of comps (traffic, volume, mix, and price) should also be carefully considered. Similar to what I’ve noticed with many businesses this quarter, deflationary benefits that aided margins in the past are now reversing. Labor costs are also a growing issue and do not appear to be transitory.

Going forward, I believe it’s going to be increasingly important for investors to monitor costs and the associated impact on margins. It will be interesting to see if investors have properly taken rising costs into consideration when making their margin assumptions. In effect, have investors been extrapolating or normalizing this profit cycle? I’m looking forward to finding out.

Have a great weekend! As Ruth’s management said at the end of their call, “As always, it’s a great day to go out and eat a steak.” Sounds good to me!

Hello Inflation, Good to See You

As I finish up my review of last quarter’s earnings reports, signs of rising costs are increasing. In response, more companies are cutting expenses and raising prices. How strong and sustainable this trend becomes, I don’t know, but it is noticeable.

Yesterday’s PPI report and today’ CPI report confirmed what I documented last week (link). In my post summarizing Q4 2016 operating results, I noted a number of companies I follow are reporting inflation is on the rise. I also provided several company-specific examples supporting my observation.

I don’t depend on government data to form my macro opinions, but in this case I have to agree with the Labor Department’s recent assessment (at least the trend). Specifically, as of January, the consumer price index is up 2.5% year over year, with core inflation increasing 2.3%. Inflation is now above the Fed’s desired target of 2%. And this is before the highly anticipated $1 trillion in fiscal stimulus, massive tax cuts, and trade wars!

Janet Yellen yesterday stated she didn’t want to wait too long before raising rates. With equity prices and valuations above the past cycle’s bubble peak and with inflation clearly trending higher, is it possible the Fed has already waited too long? We’ve been in emergency monetary posture for over eight years. How much longer do they need?

For an absolute return investor waiting in cash equivalents for a better opportunity set, I’d really appreciate a raise Janet! Can you spare 50 basis points? I think many of us know why the Fed has been so patient in raising rates. Higher interest rates can incite financial instability and deflate asset bubbles. In effect, raising interest rates threatens the foundation of the current economic recovery – and that of course is asset inflation.

Although higher rates are probably not ideal for investors fully committed to one of the most expensive opportunity sets in the history of financial markets, they’re good news for investors who have been patiently waiting for The Great Normalization. Furthermore, higher rates resulting from rising prices could force much-needed discipline on central bankers. It’s very difficult for central banks to print more money when the problem is too much money.

I don’t necessarily like inflation. I know how destructive price volatility can be (just see consequences of past two asset bubbles). And I pay the higher consumer prices too. However, as an investor longing to invest again, I want central banks out of the asset price setting process. If it takes inflation to bring back free markets, then that’s what it takes.

Consumer Prices Up Most Since Feb 2013

Desperate Value

The last small cap cycle peaked in 2007, with the Russell 2000 reaching 856 before collapsing 60% to 343 in 2009. Small cap stocks were in a bubble and the bubble popped. Today the Russell 2000 stands at 1392! Equity prices, valuations, and justifications of the current cycle continue to amaze me. How can investors and policy makers not consider today’s small cap market a bubble, when prices are 63% higher than the previous cycle’s peak? Economic growth is a rational guess, but it’s an insufficient explanation as real GDP has only grown 13% during this period. Median equity valuations are also considerably higher this cycle, with overvaluation being much broader.

While the market cycle that peaked in 2007 wasn’t as expensive as it is today, it was challenging nonetheless. At that time I was also holding an above average cash position and was struggling to find buy ideas. As value became more scarce, my equity screens became more inclusive and friendlier to special situations (a nice way of saying companies with problems).

After screening through hundreds of small cap stocks, I eventually stumbled across an interesting company I’d never seen before called Charles & Colvard (CTHR). The company was, and continues to be, a market leading provider of moissanite jewelry. According to Charles & Colvard’s website, “Moissanite is a rare, naturally occurring mineral also known as silicon carbide, which was first discovered by the Nobel Prize-winning chemist Dr. Henri Moissan at the site of a massive meteorite strike in Arizona.” Eventually scientists learned how to create silicon carbide crystals in the lab and the synthetic moissanite gem was born. While I’m not a gemologist, to my untrained eyes, moissanite gems appeared identical to diamonds.

At the time I was considering Charles & Colvard for purchase, it was a busted growth stock. The company stumbled in 2006-2007 due to a decline in earnings and elevated inventories. Their earnings shortfall was causing growth investors to panic, while value investors, like myself, took their time sniffing around for value. In addition to needing a place to invest, I had a good batting average with former growth stocks, so I was intrigued.

I began my analysis and attempted to determine if moissanite jewelry was a viable market and if the inventory problem was temporary or a longer term demand issue. After doing considerable work on the business and the evolving industry, I remained interested and thought maybe, just maybe, I finally found some value in a very expensive stock market. The thought of making a new purchase was exciting. Der’s gold (or moissanite) in dem hills! Or so I thought.

Before I completed my analysis and business valuation, I visited a department store to inspect a moissanite gem in person. The lady behind the counter was very helpful and showed me several samples. They were extraordinary gems – flawless. And they were much less expensive than diamonds. More for less is exactly what this value investor needed! It was too good to be true. And then I asked a question I didn’t plan to ask, but in hindsight saved me and clients a lot of money. I asked, “Would you rather have diamond earrings with flaws, or moissanite earrings without flaws?” The look she gave me is difficult to explain, but it quickly made me realize I just asked a stupid question. “The diamond earrings, of course,” she said.

I left the store feeling defeated and yes, a little foolish. What in the world was I thinking? Moissanite may be considered a flawless substitute to diamonds, but they weren’t diamonds. Is moissanite a girl’s best friend? Probably not. Furthermore, Charles & Colvard, founded in 1995, wasn’t an established business at the time, which is usually a requirement for companies I consider for purchase.

Due to the company’s limited operating history, it was too difficult to properly determine the business’s normalized free cash flow and its appropriate discount rate. In effect, there were too many risks and unknowns to value the business with a high degree of confidence. Investing in Charles & Colvard would have been a violation of my process and buy discipline. As much as I appreciated their gems (they really did look nice), it simply wasn’t my type of stock.

In overvalued markets such as in 2007 and today, the temptation to reduce quality and valuation standards grows along with the need to find sufficient ideas to fill a portfolio. As prices rise and investors frantically search for value, the risk of veering outside of one’s comfort, or competence zone, increases. This is especially true for many relative return portfolio managers that must remain fully invested throughout the entire market cycle. It’s quite the dilemma. Should portfolio managers buy the high quality businesses they want to own, but knowingly overpay? Or should they buy businesses that appear less expensive, but have too many unquantifiable risks to value accurately?

Having to decide between overpaying or speculating is uncomfortable and unfortunate, especially for fiduciaries (please send all complaints to your local central banker). I can’t speak for other investors, but that’s how I feel about my current opportunity set. If I allocated capital today, I’d either have to knowingly overpay, or make some aggressive and questionable assumptions. As an absolute return investor, I’m fortunate to not be forced to do either – I can simply wait.

Although I’m not required to play the game, I can appreciate how difficult it must be for fully invested relative return investors. While no one is going to admit they’re managing the Desperate Value Fund, given current valuations and the devastating drought in absolute opportunity, I suspect there are plenty of investors who feel as if they do. Hopefully portfolio managers and analysts can find a way to make today’s challenging opportunity set work. If active management underperforms on the downside again this cycle, the industry could become defenseless from the growing onslaught of passive investing.

For those professional investors willing to look different and remain true to their value disciplines, I think there could be tremendous opportunity once the current cycle ends. If I’m wrong and this cycle never ends, patience never pays, and legitimate opportunities and free markets never return…well, active management is probably dead anyway, right? Instead of acting desperately, I suggest remaining disciplined, avoid overpaying, and refuse buying assets that compromise your investment standards.

Reminder: It’s Valentines Day, so don’t forget to pick up some flowers and moissanite on the way home!

Inflation — QE Kryptonite

By now I’m sure most of you have read Bill Gross’s latest monthly commentary (link). He does an excellent job of summarizing the current investment environment and how heavy-handed central banks have inflated asset prices. I found myself shaking my head in agreement as I read his comments regarding monetary policy and its influence on financial markets. Without a doubt, Bill Gross is a great financial thinker and communicator.

While I strongly agree with his assessment of the current environment, I have trouble accepting his conclusion. Specifically, Bill Gross writes, “For now, investors must go with, indeed embrace this financial methadone QE fix.” It’s always hard to disagree with someone you respect, but as an absolute return investor, it’s important to think with an open and independent mind. With that being the case, I respectfully disagree with the bond king, and do not believe investors must go with or embrace the “QE fix”.

One of the things I like most about being an absolute return investor is I don’t feel obligated to be invested – it’s not a requirement for me. Instead of embracing central bank asset inflation and allocating capital into an overvalued opportunity set, I’m very comfortable rejecting it and watching it inflate from a safe distance. I feel fortunate to have the ability to remain patient and disciplined — many investors don’t have this option.

Intentionally sitting out a QE-induced bull market isn’t for everyone. I understand why so many are riding the wave of easy money. Investing in risk assets that are insured by central bank policy is extremely tempting. It’s more than tempting, it’s practically irresistible. Investors can enjoy the upside of asset inflation while being comforted and protected on the downside by unlimited central bank bids and forever expanding balance sheets. Can it ever get better than this? After watching stocks reach new highs again this week, apparently it can!

And I suppose Bill Gross may be right – in fact, he has been. Maybe free markets, capitalism, and investing (as I understand it) will continue to be suppressed. And maybe investors will be better served by playing along and embracing the monetary gift central banks have provided. Maybe.

As I’ve stated in past posts, there is a lot I don’t know when it comes to investing. I don’t know when central banks lose control and I don’t know when the current market cycle ends – I can’t time markets. But I do believe I’m capable of distinguishing and identifying value.

When I screen for stocks and perform valuation work on the companies on my possible buy list, I’m finding little if any value. In fact, I continue to believe this is the most expensive opportunity set I’ve ever seen. In my opinion, asset prices have been artificially inflated by monetary policy and are not supported by fundamentals or basic valuation math. Bill Gross acknowledges this, as he states the financial system is being distorted. Without continuous global QE, Bill Gross believes interest rates would be higher and we’d be in a recession. I couldn’t agree more. And I believe most investors agree.

In my opinion, the debate isn’t if asset prices are distorted. I think most investors acknowledge that without the trillions of dollars of asset purchases by global central banks, asset prices wouldn’t be where they are today. The debate is how long asset prices will remain distorted and how long investors can depend on central banks to backstop the markets.

Bill Gross believes the current investment environment will continue and states investors must embrace QE for now. But how long is “for now”? Until it ends? How will we know and how will investors – at once – be able to abruptly shift from embracing QE to running for their financial lives?

While it may appear safe to ride the monetary wave at this time, there are growing risks to embracing QE. One very important risk was noticeably missing from Bill Gross’s monthly outlook, but was apparent to me after reading Q4 2016 earnings reports and conference calls. That, of course, is inflation.

I’m not an economist, but I can get a timely and accurate view of the economy through the eyes of the 300 companies on my possible buy list. Currently, I see a deflationary mindset, turning inflationary. Even government data has picked up on this trend, with consumer inflation growing 2.1% year over year in December, according to the Consumer Price Index (CPI).

For investors relying on endless policy response and unlimited central bank balance sheets, maybe it’s time to reconsider the risk of inflation. For most of the current cycle, the majority of QE has flowed directly into asset prices. While asset prices continue to benefit, the inequality created by QE and central banks has attracted considerable attention. As a greater percentage of the population demands their fair share, will the inflationary consequences of QE spread from asset prices to the general economy? It’s possible. In fact, given current business trends and outlooks, it may be happening now.

It will be interesting to see if the CPI report replaces the jobs report as the most important economic press release of the month! If one is looking for a QE killer, rising consumer inflation would certainly be on top of my list.

In conclusion, while there are growing threats, it’s difficult to know exactly when the global central bank QE put will expire. Guessing its duration and demise is simply another form of market timing. Risk assets may continue to soar higher or they may decline sharply towards their historical averages. I really don’t know. However, based on current prices and valuations, I believe my opportunity set remains overvalued and is not adequately compensating me for risk assumed. As such, while I understand why many investors feel they must be invested and the current market cycle will persist, I haven’t altered my decision making or discipline.

Have a great weekend!