Earnings Season Summary

I’ve reviewed approximately half of the Q4 2016 earnings reports and conference calls on my possible buy list. As expected, it wasn’t a very eventful quarter with most trends and outlooks appearing similar to Q3 2016. That said, some moderate shifts in results were noticeable in specific industries. Below, I listed the major themes for the quarter. Furthermore, I included quotes from management that I found interesting or helpful in understanding where we are in the current profit cycle.

While overall earnings have stabilized and are again growing slightly, I wanted to briefly discuss the current profit cycle’s decline in 2015-2016. Although I initially believed the current profit cycle was in the process of ending in 2015-2016, that’s no longer my view.

The decline in profits, in my opinion, was mainly a result of the popping of the energy credit bubble and to a lesser extent, the stronger dollar. The sharp decline in activity within the energy industry spread well beyond E&P and energy service companies. The hundreds of billions of credit assumed and spent by the energy industry spilled over into many other sectors. When the credit boom turned into bust, this spillover effect, along with the collapse in the energy industry itself, caused a temporary decline in aggregate earnings that we saw in 2015 and 2016.

It’s been surprising how quickly the energy industry has recovered. Although it was a violent bust, it didn’t take long for investors to rescue and refuel the industry’s balance sheets with new credit and equity. And what “buy on the dip” rebound would be complete without global central bank intervention? Was it a coincidence that the financial markets and energy industry bottomed shortly after central banks announced their plans to take rates negative (BOJ) and purchase corporate bonds (ECB)? Regardless of the catalyst, capital is flowing again and the U.S. energy industry is back to doing what it does best – spending aggressively to drill holes and grow production.

In conclusion, I believe the profit cycle that began in 2009 continues today. The popping of the energy credit bubble was a stumble, but not a deathblow. I suspect the current profit cycle will ultimately conclude during the next recession. Based on the business results I’ve reviewed to date, I do not believe the Q4 2016 operating environment was recessionary. Nevertheless, in aggregate, economic growth remains subpar and susceptible to minor fluctuations in demand.

Q4 2016 Highlights:

  1. Nominal and top-line organic growth of low single-digits. While we’re not in a recession, economic growth remains slow and inconsistent. Furthermore, based on orders and outlooks, I did not sense a broad or noticeable acceleration in business activity.
  2. Easy comparisons – industrials and energy. A portion of earnings growth appears to be coming from cyclical businesses with easy comparisons versus weak results in 2015 and 2016. Barring an unexpected decline in commodity prices or the economy, several energy and industrial businesses I follow should continue to have easy comps for the next 2-3 quarters.
  3. Inflation is showing signs of increasing – the deflation mindset is ending. While it is not broad-based, there is a noticeable increase in comments and concerns regarding inflation and fewer related to deflation. Considering commodities, labor, and other input costs are beginning to increase for many companies, I expect producer inflation to eventually become more noticeable in consumer inflation. This again assumes commodity prices and wages remain stable, or increase further. I will be closely monitoring costs going forward, as it’s a very important new trend. In my opinion, the current central bank playbook will not work in an inflationary environment, nor will equity valuations. Asset prices will most likely respond very differently to a Fed that is raising rates due to inflation (stagflation) versus a Fed raising rates due to a strong economy (recovery). Currently, I’m seeing more signs of inflation than a strong economy.
  4. The consumer continues to baffle me and remains noticeably sluggish. What is causing this? Are wages not keeping up with the increasing cost of living? Why is traffic so weak? Does posting a picture of a $12 cheeseburger no longer make friends on social media sufficiently envious? Is shopping and eating out no longer an affordable or desirable event for 99% of the population. What is there to “thumbs up like” about a trip to Wal-Mart? I’ll continue to monitor closely, but it appears higher income or a new source of funds are needed to turn things around for consumer companies. William Dudley recently mentioned consumers may want to consider tapping into their home equity lines again! He may have read the same consumer earnings reports and conference calls as I did this quarter.
  5. There seems to be a more optimistic tone in commentary and in conference call Q&As. However, the increasingly optimistic tone is often attached to some uninspiring operating results. Are managements being influenced by rising equity prices and business friendly comments coming from Washington? It’s certainly possible. It will be interesting to see if rising confidence leads to new corporate capital allocation and spending decisions. I’ll be watching closely, but for now, I haven’t noticed meaningful changes in behavior and decision making.

If needed, I’ll adjust my conclusions as I go through the remaining earnings reports and calls over the next two weeks. Below I listed some supporting data and management commentary that I found interesting this quarter. I debated including considering its length, but I thought there might be a few readers who find it useful.

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International Speedway (ISCA):   In the fourth quarter, we experienced similar softening in admissions and attendance-related revenues as we did in the second quarter. Fourth quarter admissions decreased approximately 9.3% and the average ticket price for NASCAR Cup events declined to $79.62, or less than 1%. For the full year, the average ticket price for NASCAR Cup events increased to $90.12, or 5.4% increase, mostly a result of DAYTONA Rising. We believe several factors influenced the softened attendance and 2016. The impact of Jeff Gordon’s retirement was underestimated, which was compounded with Tony Stewart and Dale Junior missing races throughout the season.

The lack of activation from the outgoing series sponsor and the distraction of the presidential election season further exacerbated the situation. Our focused consumer marketing initiatives have proven successful in recent years in the face of challenging macroeconomic and industry-specific headwinds.

So for 2017, we expect total revenues to range between $660 million and $670 million. The increase is primarily attributable to the contracted broadcast rights for NASCAR’s top three national touring series. We expect attendance related revenue and corporate sales to increase less than 1%.

Q: I’m just trying to look at the outlook and think about the guidance, which is essentially flattish with fiscal 2016. And your comments regarding sponsorship and attendance revenues would seem to embed about — something like 4% or 5% decline — another decline in attendance revenues. Is that fair, John?

A: On the upper end of our guidance, we’re considering stable to some slight growth in those areas of revenue. On the lower end, as we noted in the press release, would assume continued erosion that we saw from the second and fourth quarters of fiscal 2016.

Ethan Allen (ETH): Written orders for Retail lower by 3.6% from a strong increase of 15.3% in the previous year period. Consolidated net sales of $194.7 million, lower by 6.2% from previous year when consolidated net sales increased by 5.3%

Well, I think that certainly, in many, many markets, and, in fact, nationally also, the elections did have an impact on consumers’ attitudes. And we saw that people were somewhat cautious. They were waiting. And it is somewhat better, but I think it is a little bit too early because we have seen, as you know, a still fair amount of movements with people marching and all kinds of things, which does create some issues. So I think that we saw that last quarter. It is somewhat — it is too early, but I would hope that things will settle down and people will start being more attention paying to their home and that we will move on.

We listen to what is taking place in the industry in the retail environment. And, as you know, a lot of folks are discounting. These discount 30%, 40% or they are getting 50% and 60%, and they are all (inaudible). And from the feedback we get, it is not working. Yet, everybody is on a drug. We have got to keep on giving more drugs.

Sherwin-Williams (SHW)  For the full year 2017, we expect consolidated net sales to increase a mid single-digit percentage compared to full year 2016.

Brinker International (EAT):  Our total Q2 revenues were $771 million, a decrease of 2.2% over prior year. This includes lower comp sales of 2.9%, partially offset by increased restaurant capacity of about 0.5%.

So, Q2 was kind of a tale of three cities. It started strong in October, and then we had a singular event at Chili’s in November and then an industry-wide challenge in December that created a unique quarter for us.

Unfortunately, in December, the whole category really started to get soft. We believe that’s largely driven by the shift in holiday retail traffic to online, which is starting to impact how holiday shopping patterns play out. And based on this year’s activity, some of the assumptions we have made that we’ve used regarding how to market during this time of year will have to be reevaluated.

For the casual dining category, Q2 comp sales were well below our expectation, particularly in the back half of the quarter. We believe the primary driver of this was the near-term impact of lower holiday retail sales traffic and the ongoing headwinds from lower food at home pricing.

Chili’s comp restaurant sales declined 3.3%, reflecting a 6.5% decline in traffic, partially offset by a 1.8% increase in price and a 1.4% improvement in mix.

Restaurant labor margin was unfavorable 90 basis points, primarily reflecting a wage rate increase of 3.3%, which is in line with our expectations, higher employee health insurance costs, and deleverage of 20 basis points.

Looking at full-year of fiscal 2017…we have updated our annual comp sales guidance to negative 1.5% to negative 2%. We now expect total revenues to be down approximately 2% to 2.5%, a decrease of 1% to 1.5% excluding the 53rd week in fiscal 2016.

There are a number of states that have implemented minimum wage increases and they are starting at different times. So this year, it’s really California, New York, and just in the most recent election, Arizona and Colorado. So, if it’s fairly evenly spread across our quarters and, going forward, we would expect similar levels in the future.

Now, in terms of how we are working to potentially offset it, we are working and talked about handheld technologies for our servers, and have tested that out and are beginning to roll that out in the California market where minimum wages for servers are high and growing. So, we look to use a technology that will not just help manage the cost structure, but also deliver a better guest experience.

But I do think it’s also just a broader industry phenomenon that we are experiencing. And as we’ve historically gone to this time of year, the holidays were, from our perspective, and this is how I looked at the holidays as long as I’ve been in the industry now, a time where you didn’t necessarily have to put as much pressure out there to generate traffic. People were out and about. They were shopping. There were very busy times in the restaurant, and you could play higher margin and less value promotions, and actually is a time where, if you were going to take a hiatus week from a media perspective, this would be a good time to do it, and we do this year as well as prior years. These are quarters where we take a little bit more of a break from the heavy media weight. And so I think those assumptions are all going to have to be reevaluated now in an environment where consumers may not be just out and about as much. It doesn’t mean they are not going to dine, but you may need to be — it may be a more typical environment, and how you address them, what you talk to them about during this time period may need to change.

Kennametal (KMT): Overall, the quarterly organic sales growth for Q2 fiscal year 2017 was 2%. The first quarterly growth as mentioned previously in over two years.

Some highlights of the quarter were, first, industrial organic year-over-year sales growth of 4% is the highest quarterly increase since the first quarter of fiscal year 2015.

Year-over-year, the average US land rate count in the quarter is still down more than 20%. However, there’s been some improvement each month since May and average US land rig count is up 42% since fourth quarter last year. Mining remains challenging but some signs of stabilization are beginning to occur. Construction was down in the quarter due mainly to lower sales in Asia and the Middle East.

Energy, general engineering, earth works, and aerospace and defense all posted sequential sales increases while transportation remained flat. From a regional perspective, sales increased in all regions led by Americas then Europe and Asia.

We’re seeing positive trends in oil and gas as we’ve talked about.

Our big customers are the people like Baker Hughes, Halliburton in the oil and gas area and we have very uniquely designed products for many of those customers. But we clearly are sensing from those customers an uptick in our business.

Murphy USA (MUSA): So I would say it’s over the last several years, we’ve been stuck in this anemic 1.5% to 2% GDP growth mind-set. If we break out of that and, with some of the new infrastructure discussions, corporate tax rates and the like, and we actually start growing the economy, that’s ultimately what’s going to lift up this lower to middle class consumer that we disproportionately have. So, again it’s too early to tell on that front. It’s hard to see them being impacted worse than they’ve been hit over the last several years since the, you know, 2008, 2009 recession.

Brown & Brown (BRO): For the fourth quarter we delivered total revenue growth of 7.1% and organic growth of 3.5%. Our income before income taxes and EBITDAC margins declined versus the prior year due to certain credits in the prior year and the change in acquisition earnouts.

During the quarter we continued to see modest growth in exposure units as a result of further improvement in the economy. It’s still very early days to determine the impact of the new administration, but there is some optimism about potential tax reform and how that might benefit the economy, our customers and Brown & Brown.

From a Retail perspective we grew 2.2% organically as we continue to see a positive trend in the last several quarters. We see our customers adding some employees and evaluating their healthcare options. Our customers continue to seek ways to manage their overall healthcare costs through plan or formulary design options.

Briggs & Stratton (BGG): We continue to expect the US lawn and garden — residential lawn and garden market to improve by 1% to 4%, which excludes expected — I’m sorry, which includes expected improvements in the housing market and normal spring weather in the markets.

Cullen/Frost Bankers (CFR):  The diverse and resilient Texas economy expanded 1.6% in 2016 and the Dallas Fed expects even stronger growth in 2017. Despite lingering low oil prices in the first half of 2016, the Texas economy grew faster than the national average and all other energy states. The service sector in the I35 corridor remained strong throughout the downturn.

According to the Texas Workforce Commission, Texas added 210,000 jobs last year. The unemployment rate in December was 4.6%. Texas employers continue to express concerns about finding skilled and qualified workers to meet the ongoing labor demand. This is a particular concern in major cities along the I35 corridor where unemployment rates are even lower. The Dallas Fed expects the Texas economy to grow about 1.9% in 2017 with resurgent optimism in the energy sector.

Bemis Company (BMS): Looking at full-year net sales in the US, dollars declined 4.6% compared to the prior year. Volumes were up nearly 1% for the full year. Of the remaining decline in the full-year net sales for U.S. Packaging, about half related to lower resident prices that are passed through which is neutral to profit and the other half to mix driven by the success of our asset recapitalization program.

In our US business, we have assumed 1% to 2% unit volume growth. In our global business, we have assumed 3% overall unit volume growth which is comprised of mid-single-digit growth in Asia and healthcare, low single-digit growth in Europe, and flat volumes in Latin America given the continuing tough economic environment.

I would not say there’s an acceleration or deceleration. I will talk about Q4 and U.S. Packaging for a moment.

Hillenbrand (HI):  With that, let me turn to our guidance for fiscal 2017. We are reaffirming our guidance for top-line growth, as well as earnings for the year. As a reminder, we expected consolidated revenue growth of 1% to 3%, revenue from Process Equipment Group is projected to grow 3% to 5% with growth being driven by continued strength in large plastics projects, some of which are in our current backlog.  We expect capital investment in the other industrial markets we serve across the Process Equipment Group to remain relatively stable with demand that is flat or slightly lower year-over-year. Batesville is expected to deliver revenue that is down 1% to 3%, in line with our expected annual decline in burial volume.

On frac sand, we are hearing a lot about natural gas prices are up, rig counts are up. We are hearing a lot about increased use of sand. I will tell you that there’s overcapacity in that market and we can, based on spare parts usage, etc., we can try to estimate capacity utilization in the market. And so we have a bit of a way to go to see increases in utilization that will drive capital demand. We are seeing a little bit of an uptick in parts right now, replacement parts, wear parts, but we are hearing quite a bit of noise, but we haven’t really seen it show up yet in orders and so there’s a little bit of a lag between when demand increases and we will start to see any appreciable increase in orders.

On the energy side, on the coal power side, for example, we had a little spike in December where we saw, with some cold weather and natural gas prices higher, a little bit more coal burned. We are expecting really very, very modest growth or flat in that on a year-over-year basis after a couple years of coal being down. So generally those markets — the way we characterize those markets is they continue to be flat, some even slightly down. And so we don’t expect to see any appreciable increase that will drive particularly our capital business over the next couple of quarters.

Mid-America Apartment Communities (MAA):  Tom will discuss in more detail what we are seeing in the way of leasing conditions across the portfolio, but while demand remains strong, we expect the well-documented pickup in new supply trends will cost some moderation in rent growth versus prior year. Our combined adjusted same-store revenue guidance of 3% to 3.5% is largely the result of expected rent growth and we expect to hold continued strong occupancy at around 96%, consistent with our performance in 2016. Demand for apartment housing remains strong across our markets, with leasing traffic consistent to what we’ve been experiencing over the past year.

Resident turnover or move outs in the fourth quarter were down as compared to prior year. Encouragingly, based on the trends we see, with new permitting and starts across the majority of our markets, coupled with the feedback we received from developers who find today’s construction financing markets significantly more challenging, we remain optimistic that our markets will continue to hold up well as employment markets and wage growth continue to support solid demand.

On the market front, the vibrant job growth of the large markets is driving strong revenue results. They were led by Fort Worth, Atlanta and Orlando. The secondary markets continue their steady revenue performance. Revenue growth in Memphis, Greenville and Charleston stood out.

In both portfolios, Houston remains our only market-level worry bead. After the merger, Houston represents just 3.6% of our portfolio. We will continue to monitor closely and protect occupancy in this market. At the end of January, our combined Houston markets daily occupancy was 94.3% and 60-day exposure was just 7.3%.

Renter demand remains steady and our current residents continue to choose to stay with us. Move outs for the portfolio were down for the quarter by 9% over the prior year and turnover dropped again to a low 50.3% on a rolling 12-month basis. Move outs to home buying dropped 5% and move outs to renting a house declined 14%.

John, this is Eric. I would tell you that I think based on just, again, I’ve had a lot of conversations with developers over the last several months, and it’s a consistent message that financing is very difficult right now. Equity capital is available, but the financing is difficult and on that basis, it’s hard for me to see supply trends in 2018 being certainly any worse than what they are in 2017. I would suggest that based on everything that we see right now, we likely will see supply, I believe, in our markets peak this year and portfolio-wide see a lower moderation take place in 2018.

Well, I think that there has been a lot more information available and widely sort of put out there suggesting that supply trends have picked up quite a bit, particularly in the high end of the market and in some of the more urban locations. As a consequence of that, I think the financing environment has just become a little bit more cautious about funding and financing apartment construction at the moment. As a consequence of that, again, I wasn’t actually in attendance, but I talked to a lot of people coming out of the National Housing Conference last week and that was absolutely a consistent message that financing is just very difficult to come by right now.

When you put on top of that the rise in land costs, construction costs, construction labor in particular is becoming increasingly challenging, it’s just hard to see at this point how supply trends begin to elevate in any way from where they are today. In fact, as I said a moment ago, I believe they will likely see fewer deliveries in 2018 versus what we’re seeing in 2017.

Whirlpool (WHR): Turning to slide 5, to look at our full-year results, our full-year revenues grew by 2%, excluding the impact of currency.

Turning to slide 10, we have outlined our 2017 expectations and operational priorities for the North America region. We expect that the industry to grow by 4% to 6% behind continued solid macro trends, including housing, real wage growth and lower unemployment. Our expectation is that the industry strength will continue in mass segments and we plan to pursue opportunity to drive positive mix through strong case of new product introductions.

Since we first provided our 2018 goals over two years ago, we have experienced significant changes in the global economic environment. As we talked about previously, we believe that we are in a strong dollar era which is not likely to change soon.

I think there’s a myriad of reasons out there and it was touched on in the Journal this morning with the new home buying stats, the homeownership rate dropping again. I just think it is people pushing back major life decisions. They’re buying homes — they’re getting married later, they’re buying homes later and they’re investing in their pets, and so they tend to want to rent longer and value that flexibility.

Helmerich & Payne (HP):  Since the trough of the downturn in May of last year, we have more than doubled our number of active rigs to a current level of close to 140 rigs.

Looking ahead to the second quarter of FY17, we expect a sequential increase in activity in the range of 30% to 35% in terms of revenue days.

Okay. I think there’s no doubt that we have some pricing power in the market, now. I mean obviously, everyone has been pleasantly surprised with how quickly things have moved. And so it has been hard to keep up with it, quite frankly.

But there is pricing power, as well as I do, it’s pretty hard to see out past this quarter. We obviously have a lot of calls coming in, and customers wanting rigs. And for February, March, and even some April deliveries. And so with that, we would expect to see some continued pricing.

John, we really don’t have any positive outlook in that respect. I think you have heard several people say — and we’ve known this for several months, that while we hit the bottom in US land last summer, it may this summer before we completely hit bottom in international. So we don’t really have any insight.

LSI Industries (LYTS):  Net sales in the quarter increased 1% year-over-year.

Inflationary pressures affected raw material costs, especially steel and aluminum; and freight costs increased as a percentage of sales.  We also saw increases in commissions, wages, and health benefits, though some of this impact was blunted through Lean activities aimed at cost reductions.  Our gross margin for the quarter was 25.0%, or 25.7% excluding restructuring costs, compared to 28.3% a year ago.

As we look ahead to the second half of fiscal year 2017, we see a landscape filled with both challenges and opportunities.  Inflationary pressures, particularly for raw materials, are trending upwards.  We have begun to offset this impact by initiating appropriate pricing strategies, as well as a continued drive towards greater efficiency through the LSI Business System.  With regard to market dynamics, there are a number of factors at play.  While we experienced softer demand during the first half of fiscal 2017 overall, December results showed signs of strength.  We are cautiously optimistic that this trend will continue into the second half.  We are paying close attention to the new Administration as it pursues new tax and trade policies, and believe that our strong U.S. manufacturing capabilities may be of benefit with regard to trade policies.

Lancaster Colony (LANC): We saw total net sales growth in our second quarter of 0.6% with our retail channel sales growing approximately 3%, offsetting a 2% decline in our foodservice channel sales.

Heartland Express (HTLD): Operating revenues excluding fuel surcharge revenue(1) decreased 19.9%, primarily due to lower miles driven due to softer freight volumes in the fourth quarter compared to the same period in 2015.

Gains on disposal of property and equipment declined $25.8 million year over year as a result of less trade activity in 2016 following our fleet upgrade in 2015.  These results were achieved even though our top-line revenue was challenged by significant pricing pressure from shippers attempting to capitalize on short-term excess capacity in the industry.

Arthur J. Gallagher (AJG): Fourth-quarter organic growth was 3.6% all in, right in line with our full-year result. Domestically we saw about 3.5% organic growth in the fourth quarter with retail property casualty up a little more than 3.5% and wholesale and benefits up a little less. Property casualty rates continue to be a slight headwind offset somewhat by exposure growth. Combined rate and exposure reduced our domestic PC brokerage organic by about a point.

Okay, to wrap up my organic comments, when I look forward I am seeing an environment much like 2016, so right now 2017 organic feels like it will be similar to 2016.

Q: You did point to the pickup in deal activity in the first quarter and multiples seem about in line with what you saw in 2016. Are you seeing some sellers potentially either looking for higher multiples, or waiting just given the uncertainty around the US corporate tax reform?

A: Yes, there’s two things. There’s an interesting dynamic there. I think that the sellers that really are interested in staying in the business want to do the right thing for their employees, continue to work hard and sell insurance and really recognize our capabilities. They are really looking at — they are willing to sell for fair multiples. And what I mean by fair is somewhere between 7 times and 9 times.

But there is pressure on pushing multiples up out there. 

Starbucks (SBUX):  Global comparable store sales increased 3% comprised of a 3% increase in the Americas, a 5% increase in CAP, and a 1% decrease in EMEA. U.S. comparable store sales increased 3% comprised of a 5% increase in average ticket and a 2% decrease in transactions

Hill-Rom Holdings (HRC): Finally, let me conclude my comments this morning by providing our updated 2017 financial outlook, which does not include any impact from the acquisition of Mortara Instrument. For the year, we now expect revenue growth of approximately 1%. On a constant-currency basis we expect revenue to increase approximately 2%.

Graco (GGG):  Our worldwide outlook for 2017 is for low single-digit growth with similar growth rates throughout the geographic regions.

So, we did have a good year in China really across the majority of our product lines. Still, I think we are a little bit cautious in terms of the project activity there going into 2017.

Q: And I just want to get your thoughts if you see that improving, since you’ve seen some more positive manufacturing data.

A: I can’t — it still seems to me to be on kind of a flat trend going forward.

I’d say so far the trends kind of look a lot like 2016. So we are hearing some positive things, but I think we’re going to wait until we actually see it to make positive comments.

Q: And then just a follow-up, and it might be early, but do you think that the proposed tax changes could be a catalyst to boost US manufacturing investment?

A: You know, we have discussions of course around here from time to time. I personally try not to engage too deeply in them. I think it’s hard to predict how all the dynamics are going to play out. And I can create scenarios that are great and I can create scenarios that are disastrous, and I think the devil is in the details. We’re just going to continue to do what we do, and as the picture becomes clear, we will make sure that we are making our decisions in the context of whatever the environment is.

So automotive has been pretty good globally. 2016 was a pretty good year and obviously, in some of the areas, we are approaching peak. I think investment is still going to be okay in 2017. I’m not worried about a big collapse. The numbers for EMEA look like they were pretty strong finishing up the year and they are forecasted for continued growth and going into 2017. North America is at high levels, but there still seems to be some activity. So I feel okay about automotive.

I would say that there was probably some — I felt some optimism talking to some of our salespeople, a few of our channel partners, but I would say, from a run rate perspective, it seemed like more of the same. I don’t think there was any kind of a dramatic reaction either way in terms of actual orders.

Again, we get into a lot of predictions and stuff in terms of what may or may not happen. We went through this whole shovel-ready thing a few years ago, and things weren’t as shovel-ready as everybody thought. Obviously, any time there’s construction activity, it is going to be great for Graco. I haven’t built that into my forecast. My forecast assumes that things are running pretty much like they are today. So, if you view that there is going to be a lot of infrastructure activity that’s going to happen already in 2017, you’ve got to view that as favorable for us.

Crane (CR): Sales of $681 million were approximately flat compared to last year, with 2.5% organic growth mostly offset by unfavorable foreign exchange.

We have also been very pleasantly surprised by strengthening demand in the developed markets, driven largely by concerns over rising wage rates and a more intense focus on productivity for retail and banking applications.

Our guidance assumes total 2017 sales of approximately $2.7 billion, down 2% compared to 2016. This sales outlook includes an approximate 3% negative impact from foreign exchange, 0.5 percentage point impact from divestitures, and core growth in a range of flat to up 2%.

Packaging Corporation of America (PKG): Corrugated product shipments excluding TimBar set all-time records for both total shipments as well as shipments per day with our shipments up 1.7% in total and per workday compared to the record third quarter of 2015. As a comparison, the industry was up 1.5% in total and per workday.

Werner Enterprises (WERN):   Freight volumes and transactional spot market pricing in the one-way truckload market improved in fourth quarter 2016 from third quarter 2016. We experienced more typical seasonal freight volumes in One-Way Truckload in fourth quarter 2016 which were better than fourth quarter 2015. Freight demand thus far in January 2017 has been softer than normal in One-Way Truckload; however, with our reduced truck count in One-Way Truckload, our prebooks of loads compared to trucks are slightly better than January 2016.

Average revenues per tractor per week decreased 1.9% in fourth quarter 2016 compared to fourth quarter 2015 resulting from a 3.8% decrease in average miles per truck combined with a 1.9% increase in average revenues per total mile. Shifting trucks to shorter-haul Dedicated from longer-haul One-Way Truckload had a favorable impact on revenue per total mile and an unfavorable impact on miles per truck.

During fourth quarter 2016, we experienced freight strengthening which further validated our pricing strategy. In second quarter 2016, the contractual rate market was very challenging, particularly in One-Way Truckload. An excess supply of industry trucks relative to sluggish freight demand created a market in which some customers pushed hard and obtained contractual rate decreases. At that time, we chose to exit from certain contractual business that would have required mid-to-high single digit contractual rate decreases for the next year, since we believed that this pricing was not sustainable. In fourth quarter 2016, transactional spot rates demonstrated material improvement, and contract rates began to stabilize for new contracts. Expectations are rising for improved pricing in 2017, noting a more positive economic outlook, rationalizing industry truck supply, normalized current customer inventory levels and the much anticipated supply-constricting December 2017 electronic logging device (ELD) regulatory mandate.

The driver recruiting market remains challenging. Several ongoing market factors persist including a declining number of, and increased competition for, driver training school graduates, a low national unemployment rate, aging truck driver demographics and increased truck safety regulations.

We realized lower average gains per truck and trailer in fourth quarter 2016 compared to fourth quarter 2015. The used truck pricing market remained very difficult in fourth quarter 2016 due to a higher than normal supply of used trucks in the market and low buyer demand. We expect the tough used truck pricing market will persist in 2017.

Diesel fuel prices were 14 cents per gallon higher in fourth quarter 2016 than in fourth quarter 2015 and were 12 cents per gallon higher than in third quarter 2016. For the first 30 days of January 2017, the average diesel fuel price per gallon was 63 cents higher than the average diesel fuel price per gallon in the same period of 2016 and 54 cents higher than in first quarter 2016.

Knight Transportation (KNX): Revenue for tractor excluding fuel surcharge decreased 0.4% year over year, as a 1.2% decline in average revenue per loaded mile offset the improvement in average miles per tractor. Revenue in our brokerage business grew 6.3% as a result of an 8.2% increase in load count offset by a 1.7% decline in revenue per load.

We expect capacity to continue to tighten as a result of low new truck orders, a weak demand for used equipment and additional regulatory burdens expected to phase in over the coming quarters.

We continue to execute on our strategy of managing inflationary pressures in order to maintain the lowest cost per trucking segment and the lowest cost per transaction in our logistics segment. During the fourth quarter we faced several challenges that impacted earnings.

Fuel prices steadily climbed during the quarter and led to a higher net fuel cost than originally estimated. Demand for used equipment remained particularly weak and resulted in gain on sale below our expectation.

We expect driver wages will continue to be inflationary on a year-over-year basis, probably similar to what we experienced in the fourth quarter of 2016. We also expect gain on sale in the next two quarters will continue to be a significant headwind, as the used equipment market remains very challenging.

Where in November we did see some continued spot market activity, but maybe did not see the acute tightness that we were expecting. Now, it was certainly better than 2015, but maybe not as strong as 2014 or 2013.

But pricing did continue to improve from October to November, really driven by the spot market activity. But we also started to feel some of the cost pressures from fuel and gain on sale, they became a lot more evident as we were looking through November’s results.

And then in December, that spot market began to loosen up a little bit and we did not have nearly as many opportunities as we were hoping for. Now, miles were still improved and the cost pressures certainly were still there in December that we had begin to feel in November. So really that sequential — that 1.4% sequential improvement really has been a result of the spot pick-up that we saw in October, and then in November and the kind of the tail end in December.

First, talking about January. Yes, I think we have seen the December — the kind of some of the looseness, if you will, in December to continue — that we saw in late December continue into January. So I would say that January has not been overly robust.

A couple things to take into consideration, and that is I think that the way that the holiday fell started the new year off to a pretty slow start. When you have a Sunday New Year’s Day with it recognized on a Monday, we got off to a little bit of a slow start.

And then we’ve had a heavy dose of weather so far in these first few weeks of January. So when we look at — when we measure the freight market from a load volume perspective and a miles per truck perspective, it has been a bit challenging.

ODFL: I will begin by saying that the overall fourth-quarter operating environment was similar to what we experienced throughout 2016. We had a slow start to the quarter, but our revenue and tonnage marginally improved on a year-over-year basis as the quarter progressed.

Our LTL tons per day essentially trended in line or slightly above normal sequential trends for November and December. This continued into January, as LTL tons per day were also in line with normal seasonality. These trends combined with the increase in LTL weight per shipment and other improving macroeconomic indicators for the fourth quarter provided us with a sense of cautious optimism for an improved economy in 2017 which also concurs with economic forecasts for improved GDP.

We obviously did not have benefit of a strong economy in 2016, and the reduction in volumes did not help with density. As a result, we were unable to average our fixed cost to improve our operating margin in the fourth quarter and the year. Our OR increased 30 basis points for the fourth quarter and 60 basis points for the year.

Hubbell (HUBB): Certainly, I’m pleased after having a challenge every month and every quarter throughout the year, you see the fourth quarter, we had sales up 3%. Now, that was driven largely by acquisitions. They contributed 4%, and we had, still, a point of FX headwind offsetting that. So the result, organic sales were flat.

From a macroeconomic perspective, the end markets continued even in the fourth quarter, with what I’ve said throughout the year to be sloppy and choppy. Although, I’ve certainly hope I can stop making that reference in 2017. I think, certainly, that is going to moderate, maybe with a little more predictability on the underlying markets.

But some of the important markets like oil and core industrial, certainly showing signs of stabilization on a sequential basis. When we look at some of the broad economic indicators, we’re seeing strength in the residential construction market, driven by single-family and improvements.

And the leading indicators for the non-residential markets generally point to growth. We’ve seen in the fourth quarter the ABI trends recently indicated growth in billings, the Dodge Data is more promising, and the non-res permits continue to slope higher.

But at the same time, some of the NMEA Data, which really has got more specificity to the electrical industry, is a little more modest, and particularly around lighting, where some of their forecasts suggest the luminaire markets was down in the fourth quarter and may be flat in 2017.

For our core industrial energy markets, our year-over-year quarterly declines in the total industrial production are moderating. And, I think you saw in December, the ISM was up, and manufacturing output was up. So that’s certainly a favorable trend for heavy and light industrial businesses.

And US to worldwide rig counts still significantly off-peak. But they have been increasing, and certainly as you know, more rig activity bodes well for Harsh and Hazardous business.

So, let’s turn to 2017, and what are we looking at this year? First, let’s talk about the end markets. We’re cautiously optimistic about 2017. We think the overall — cutting to the chase, we think end markets, for us, will be up approximately 2%. Which is still a slow growth environment, but certainly feels a lot better than a flat markets we saw overall in 2016.

Equally important, I think there’s going to be — we think there’s more consistent growth across the end markets than what we saw in 2016. I mentioned, hopefully were not talking about sloppy and choppy — more consistent, and particularly against all of our markets, as you see in the pie chart on page 14, flat to up. We haven’t seen that for a couple of years. So, that’s the good news, even if it’s modest.

We’re not expecting a V-shaped recovery in oil markets, although the recovery could be stronger than 0 to 2 that were planning for. And we certainly have the capacity to capitalize on that growth, but right now we’re just being a little bit cautious in that area particularly, with the — because it’s such a high margin, it creates such volatility in our outlook. We’re going to be a little bit biased there.

And, I think, to the extent that some of the proposed policies, and investments, and more stimulus in infrastructure could certainly support improvement in there, but I don’t think we’d see that until the end of the year, at best. That would be more of a 2018 impact for us.

Of course, the wild card’s still — all of that growth is some of the things are front and center today, both trade and tax policies. So, much too early to size the impact of that. I think for us, clearly, there some implications as a net importer, border taxes would have an implication on us.

Norfolk Southern Corp (NSC): Our merchandise revenue declined 1% to $1.5 billion as a result of a 3% decline in volume. Metals and Construction volume benefited from increased steel shipments. Agriculture shipments grew due to increased soybean export and corn volumes. Declines in our chemicals market were driven by lower crude oil volume. Automotive volume was negatively impacted by the previously-announced market share loss and flat year-over-year US vehicle production in the fourth quarter. Paper and forest products volumes declined as a result of increased truck competition.

Merchandise revenue per unit increased 2%, excluding fuel, reflecting solid pricing gains.

Overall, 2016 was challenging for many of the markets we serve with depressed energy prices, weaker-than-anticipated economic growth, elevated inventory levels and increased truck capacity all impacting our top-line performance, although we saw stabilization as the second half progressed leading to volume growth in the fourth quarter. Recent improvements in manufacturing and consumer spending, as well as overall expectations for a stronger 2017 economic environment, provide upside potential for the year ahead.

As we look to 2017, we expect that total headcount will remain steady despite the anticipated increases in volumes that Alan described. However, higher health and welfare rates, particularly in our unionized programs, will result in approximately $65 million of additional expense and as a result, we expect all-in wage and medical cost inflation of about 5% versus the 3.5% we guided to and experienced in 2016.

Coal is projected to increase in 2017 from our 2016 base as inventories and weather normalize, coupled with higher natural gas prices. It is then expected to decrease slightly from 2017 levels, resulting in a modest 1% increase on a compound annual basis over the combined period.

CSX: Thank you, Michael, and good morning, everyone. Revenue was up 9%, or $256 million, versus the prior year, driven primarily by higher volumes as a result of the extra week. Total reported volume increased 5% in the quarter, but declined 1%, excluding the extra week.

We continue to deliver strong core pricing from an improved service product. Same-store sales pricing for the fourth quarter was up 2.8% overall and 3.2% excluding coal. In addition, fuel recoveries declined $10 million in the fourth quarter, but were more than offset by a $13 million increase in other revenue.

We expect volume to be flat to slightly up year over year in the first quarter as the industrial economy is stabilizing and energy-related headwinds are moderating slightly. That said, a number of our markets are returning to year-over-year growth in the quarter as we cycle the challenging conditions of early 2016.

As you can see on the slide, nearly 80% of volume falls in the neutral or favorable category in the first quarter, while a little over 20% of the portfolio is expected to be unfavorable. Agriculture and food is expected to grow as the record grain harvest and new customer facilities are expected to more than offset the strength in the US dollar and the strong South American crop, which curtails the US grain exports season earlier than normal.

As we think about the full year 2017, we anticipate a healthier volume environment. As a result, we expect a combination of merchandise and intermodal to grow on a comparable 52-week basis in line with the economy. In addition, excluding the short-haul competitive loss of about 6 million tons, we expect domestic coal tonnage to be roughly flat to 2016.

Overall, CSX has delivered solid financial performance in 2016 despite a dynamic freight environment that impacted nearly every market. This success was driven by pricing for the relative value of our service, driving record, efficiency gains, and aligning resources to the softer demand environment, which partially offset the 5% decline in total volume.

The Scotts Miracle-Gro Company (SMG): The one commodity we’re watching most closely right now is resin, which is challenging to lock in for more than one quarter at a time, so our remaining exposure may be at a slightly higher cost than we planned.

Pentair (PNR): Now on a core basis sales were down 1% and segment income was up slightly, which was in line with results from other industrials. For 2016 total sales grew 6% with core sales declining 1%. As I mentioned previously, segment income grew 11% and operating margins expanded 80 basis points. Adjusted EPS grew 8%.

As Randy mentioned, for the full year 2017 we are expecting overall Pentair EPS to be around $3.45 to $3.55 on an adjusted basis. We expect to achieve this guidance on core revenue of down 3% and margin expansion of 120 basis points driven by simplifying the organization and the resulting cost out from those efforts.

On the pricing side, we are getting a little bit more price and we expect to because of the commodity inflation that we are seeing.

Q: It sounds like you guys are saying no fundamental improvement from current run rate assumed in the 2017 guidance. Do I have that right? In other words pretty normal sequential pattern assumed through here, is that the thought process?

A: Yes. As you look at the waterfall that John showed you don’t see a lot of lift from growth. And that is where we would expect higher execution in sales and any recovery of market would read out.

Q: One on organic sales, the little bit of lower guidance that you are putting out here today. Is that — I know you just indicated that you are no longer expecting an uptick?

A: Scott, I mean candidly I will share with you that a big piece of what we are trying to figure out on a longer-term basis is the impact of a stronger dollar globally and the global competition and how that affects our growth views.

And then there is a lot of global change that has occurred in the last three months — a new presidential administration, there are some tax — emerging tax strategies there but none of that has been identified, none of that has been decided. So what is the impact on that going to be to industrial investment?

Potlatch (PCH): Looking ahead to 2017, we anticipate US housing starts to be between 1.2 million and 1.3 million units and we expect repair and remodel markets to remain strong. We expect our harvest and lumber shipment volumes to be flat compared to 2016. We also expect to sell about 20,000 acres in our rural real estate segment this year.

Upside relative to our 2016 results would be driven by higher lumber prices and continued increases in the price of cedar sawlogs. We believe that the softwood lumber trade dispute with Canada will cause lumber prices to be volatile. The US International Trade Commission made a preliminary ruling earlier this month that Canadian lumber imports have caused injury to the US industry. This means that the US Department of Commerce will continue its investigation into the petition filed by the US lumber coalition.

Well, the timberland M&A market was pretty active in 2016. There were — setting aside the Weyerhaeuser/Plum Creek transaction, there were dozens of smaller deals in that $50 million to $500 million range. We evaluated several of those and elected not to purchase any of them in 2016. So I think the market’s been pretty robust. We expect that to continue with the maturing of some of the TIMO funds and the need for some of their investors to liquidate, and we expect there will more property on the market.

I think it’s a foregone conclusion that tariffs are going to be implemented later this spring. We view those as an interim step to a negotiated agreement that establishes a quota on Canadian lumber, and I think the industry’s united in that. And it’s really important because it’s one that allows the US producers to invest and grow our lumber business here. There’s plenty of logs available. Housing starts are improving. There’s a good demand for the product. But we need to do that without being impaired by unfairly traded Canadian imports. A quota’s really the only thing that solves that.

UPS: In the US, GDP growth for 2017 is forecast to be slightly higher than last year. The expansion of e-commerce is expected to continue with another year of double-digit growth.

On the commercial side of the economy, industrial production outlook has gone from negative to slightly positive. That favorable move is a good sign for the manufacturing sector. However, US exports are expected to face continued headwinds from a strong US dollar.

Global growth estimates for 2017 have been largely unchanged. The outlook for both Europe and China has rebounded slightly, although economists are still expecting slower year-over-year growth.

Monro Muffler Brake (MNRO): There were 90 selling days in the current quarter and 89 in the prior year third quarter. Adjusted for days, comparable store sales increased 1.1%.

As we’ve recently discussed, we believe the consumer remains under pressure with stagnant wage growth, increasing rents, and resets on healthcare deductibles and increasing premiums impacting their spending. This is adding to the choppiness of the market which is reflected in our recent top-line results.

Based upon our updated fourth-quarter guidance, we are lowering our expectations for FY17 comparable store sales to a decline of 3% to a decline of 2.5%, compared to our previous guidance which called for a decline of 2.5% to 1.5%.

Vehicles 13 years old and older continue to account for 29% of our traffic in line with the previous quarter and up from 27% last year. These vehicles produce average tickets similar to our overall average, demonstrating that customers continue to invest in and maintain their vehicles even as they advance in age.

To give you some detail, recent increases in raw materials have led many tire manufacturers to announce price increases in the mid single digits beginning with February 2017 orders. However, it’s worth noting that not every manufacturer has announced the price increase, and some manufacturers are offsetting these price increases with additional volume rebates.

Before I conclude, I want to briefly address questions I’ve received regarding potential new government policy changes. Quite simply, we don’t know what the impact of these changes will have on Monro until we see the exact details and the government’s plans. I can tell you that a reduction in the corporate tax rate would be a significant benefit, given that our effective tax rate is around 38% on $100 million of pretax income.

Having said that, we do hope that there are adults in the room during these policy discussions as they may be far-reaching, impacting in the majority of US companies across multiple industries not to mention significant price increases to US consumers. Our investors should also take comfort in the fact that any additional pressure on our industry, whether from tire cost increases, changes in import policy, or continued consumer pressure will create additional acquisition opportunities over time which will only strengthen our competitive advantages.

Energizer Holdings (ENR):  However, we are operating in a macro environment with heightened volatility. As we experience additional negative currency movement, it will become increasingly difficult offset within the current fiscal year.

Looking at our specific assumptions in more detail: total reported net sales for the year are expected to be up mid-single digits. Organic net sales are expected to be up low single digits. 

Park Electrochemical (PKE): So if these tax laws go into effect as people are discussing and if and when they do, that will be an opportunity for Park to repatriate significant amounts of cash. At that point, whatever the tax laws are, they are, and there’s no reason to continue to wait. We’re not going to wait another two years or four years, whatever.

At that point, we would expect to pay a large cash dividend.

The third quarter is pretty much a continuation of the second quarter in terms of it being an electronics story, electronics continue to be weak, the electronic revenues continue to be weak as you noted already from mass commentary. Aerospace is not really the story here in terms of explaining the P&L weakness and the top line weakness, it really continues to be an electronic story, at least it did in the third quarter continue to be an electronics story.

So as far as the fourth quarter is concerned though, I thought you’d be interested to know that we got off to, I would say, a very good start. We have five weeks in the books, there’s a five-week month of December. So the bookings, the revenues and especially the bottom line is coming in quite strong in the first five weeks of the fourth quarter, that’s basically the month of December, which is interesting because normally you might expect the summer to be a little weak because the two weeks of holidays that are inter [weaved] into the December month.

CSG Systems (CSGS): Total revenues for the fourth quarter were $195 million, a decrease of 1% from the same period last year. Sequentially, revenues were up 3% from the third quarter. Total revenues for the full year of 2016 were $761 million, an increase of 1% over last year, and slightly above our full-year expectations

AO Smith (AOS): Sales in our North America segment of $436 million increased 5% compared with the fourth quarter of 2015. The increase in sales was primarily due to higher volumes of commercial water heaters and boilers in the US and pricing actions in August 2016 related to significant steel cost increases and inflationary pressure on other costs. Lower US residential volumes partially offset these factors. Aquasana added $12.2 million to our North American segment sales.

Ingredion (INGR): I also look at the GDP forecast in Brazil, and it is still positive for 2017, which is a change from the negative in 2016. So we would expect Brazil to continue on a positive trajectory, but again, it is still a challenging environment there, though our team has done very well in optimizing the footprint.

I think the big challenge is really in Argentina, and the government has taken some very good steps to do the right thing for the economy long-term. It has been a little bit painful for some of the consumers during 2016 when the government removed some of the subsidies on the utilities, and so consumers had less disposable income and they moved that around. And so we don’t see it going back to the 2013 level for us for 2017, but yet an improvement over 2016.

McDonald’s (MCD):  Sales at established McDonald’s restaurants in the United States declined 1.3% in the three months ended Dec. 31, 2016.

The Finish Line (FINL): Following the back-to-school season, we have projected sales to improve meaningfully over the remainder of the third quarter, due in large part to easier comparisons as a result of our last year’s supply chain disruption. Unfortunately, October and November were more challenging than we expected, marked by weak traffic trends.

Q3 comps ended up 0.7%, including a mid-single-digit increase in November. However, this was well below our expectations for a gain in the high single-digit range. Soft goods was the major contributor to our third quarter sales and earnings shortfall as comps declined 37% with apparel and accessories both significantly underperforming our expectations.

Unfortunately, softer than expected demand for cold weather gear more than offset gains in less seasonable categories. Our go-forward strategy also involved exiting our entry price point NCAA fleece program.

Looking ahead, we expect the category to remain challenging in the near term, and this has been factored into our revised full-year guidance.

With respect to the holiday season, as expected, we experienced strong digital sales over Black Friday weekend and through the first few weeks of December before traffic began shifting more heavily to brick-and-mortar this past

weekend. The selling environment has been more promotional than last year and we expect this trend to continue through the remainder of the fourth quarter.

Our fourth quarter projections reflect the continuation of our challenging soft goods trend and the negative impact from the delay in tax refunds, which will shift sales out of February and into March, the first month of our next fiscal year.

Ball Corp (BLL): Industry demand across North America grew 0.6% in the fourth quarter and 1.2% for the full-year 2016.

When you talk about some of the things you talk about, there is inflation. I just think about steel and steel has been going — is up upper single-digits. You talked about energy; we do a pretty good job of managing that.

One of the things that actually could be over the next couple of years, there is always a lagger on that but could be net benefit to that is we have various mechanisms that we have to pass through the inflation or, candidly, deflation as well. And over the past couple years we have actually had to pass through deflation.

So in an inflationary environment we should be able to recapture any cost and through the efficiencies that our folks continue to work on, we think there is — net-net-net it is certainly not a negative. And if we do this correctly and take the costs out appropriately, it could be a positive.

Ralph Lauren (RL): Moving to comparable-store sales. On a global basis, comps decreased 4% in constant currency.

For fiscal 2017, we are maintaining our guidance. We continue to expect revenues to decrease at a low double-digit rate as we execute the Way Forward plan. Based on our current exchange rates, foreign currency is expected to have minimal impact on revenue growth in fiscal 2017.

Dave, while foreign tourism was still down in this quarter, we are seeing a sequential improvement to what we saw in the first and second quarters of this year, so still pressured in foreign tourism, but a significant improvement from what we saw as we exited the second quarter. And certainly, the declines are about half of what we saw in this same quarter last year, so overall improvement.

Yes, we are anticipating door closures with our retail partners. In fact, as of the end of Q3, we have worked closely and collaboratively with our department-store partners and have worked through about 70% alignment on the point-of-sale closures that we announced last quarter that would reduce our points of distribution in department stores by 20% to 25%, so we are well underway there.

Target (TGT):  Target Corporation announced that comparable sales during the combined November/December period decreased 1.3 percent.

Target now expects fourth quarter comparable sales in the range of (1.5) percent to (1.0) percent, compared with prior guidance of (1.0) percent to 1.0 percent.

“While we were pleased with Black Friday sales, December digital sales growth of more than 40 percent and continued strength in our Signature Categories, these results were offset by early season sales softness and disappointing traffic and sales trends in our stores,” said Brian Cornell, chairman and CEO of Target.

Snap-on (SNA): Our organic growth in the quarter was 3.6%, with gains registered across every group. Now, for the full years, sales were $3.43 billion, and, as reported, increase of 2.3%. The organic volume gain was 2.9%.

Okay, the tools group was not equal to its normal trend, but 3% isn’t a poke in the eye with a stick in a 1.9% economy, so we still feel okay about that.

Hanesbrands (HBI): But 2016 wasn’t without its challenges, particularly in the fourth quarter. Last year in the US, roughly 1,200 retail doors closed, several retailers filed for bankruptcy, and there was further inventory tightening as the retail industry continued to adjust to the disruption caused by the shift to online.

Store traffic trends during the holiday came in below even our various expectations, and a large mass retailer cut replenishment orders in the key November and December periods. Both of these impacted our revenue and profit in the quarter.

So as we look forward, we expect the overall retail environment in the US to remain challenging as the ongoing channel disruption drives additional store closings and tighter inventory management. That said, we believe we are well positioned to manage through these near-term challenges.

And fourth, we planned more conservatively within the bricks-and-mortar channels for 2017. The shift online is not only pressuring store traffic, but it is also reshaping traditional shopping patterns as store visits are becoming more concentrated around key promotion events. Therefore, we’re going to be more targeted with our promotions and we are planning for tighter inventory management at retail.

Thanks, Gerald. When we entered 2016, you may recall that we took a very cautious view of the overall US consumer environment, particularly the holiday period. Unfortunately, the environment proved to be more challenging than even our bearish assumptions.

This created two headwinds that weighed heavily on our basics business and accounted for the vast majority of the miss relative to our guidance. First, within the midtier and department store channels, the lower-than-expected traffic trends drove reduced point-of-sale, which resulted in fewer reorders.

So Michael, I hope that’s helpful to kind of give you a sense of where we think that — and thus, and you put all that together, we have a — at the low end of our guidance, we are talking zero organic growth. For the top end, we’re talking about 2% — actually a little less than 2% organic growth. We think that given all those factors, that’s a reasonable expectation.

Central Garden & Pet (CENT): And organic revenue growth was 6% and reflects widespread increases across the Pet segment which benefited from a shift in timing of orders into Q1. With more difficult costs later in the year we would expect our Pet organic growth to be less robust than it was in the first quarter.

Similar to what has been reported by others [garden business], the favorable weather, the milder temperatures in the fall favorably impacted our business. We saw strong consumption really across the board on all of our businesses. Probably the strongest performers were grass and our branded controls.

Regis (RGS): After adjusting for the Christmas calendar shift, same-store sales for our Company-owned salons declined 2.4% in the second quarter.

Adjusted same-store sales for our non-mall brands were down 1.2% and continued to outperform our mall business, which posted adjusted same-store sales declines of 5.8% in the second quarter.

The “I Warned You” Card

Bloomberg ran a timely article today on commercial real estate. It fits nicely with my post yesterday on Pinnacle Financial (PNFP) and the Nashville commercial real estate market. Specifically, the article “Yellen Eyes Commercial Real-Estate Froth as Fed Weighs ’17 Risks” discusses how there is debate within the Federal Reserve regarding the possibility of a growing bubble in commercial real estate (article link). According to a chart from the article (below), commercial real estate prices are 20% higher than they were during the peak of the last real estate bubble.

The article quotes Janet Yellen as stating she is worried bubbles could form in the economy and the Fed is currently monitoring commercial real estate. According to Yellen valuations are high, but it remains difficult spotting bubbles in real-time. Is it really that difficult? I don’t think so. I believe spotting excessive asset inflation and bubbles is relatively easy; however, taking corrective action and facing the consequences is extremely difficult.

An even tougher decision for the Federal Reserve, is resisting the temptation to correct policy mistakes and past asset bubbles with future “bailout” bubbles. Unfortunately, I believe we’re well past that fork in the road. Asset prices are where they are – the policy decisions and asset purchases (by investors and central banks) have already been made. With the Fed maintaining its bloated balance sheet and an emergency policy stance, the Federal Reserve may be concerned about asset bubbles, but they’re obviously not doing much about it.

Do professional investors really need a warning about asset bubbles? Given current prices and cap rates, I find it hard to believe that sophisticated commercial real estate investors aren’t aware prices are expensive. This applies to other asset classes too. I believe most professional investors are very aware asset prices are inflated, but are trapped in the relative return game. Similar to stock and bond portfolio managers, professional commercial real estate investors are paid to find and buy commercial real estate. Do Fed members really expect raising short-term rates from 0% to 0.50% (over eight years) is going to cause professional investors to become more prudent and assume career risk?

After the last real estate bubble popped, some policy makers blamed regulators. Today the Fed is again discussing the need for regulation. From the Bloomberg article, “Fed officials have mostly said they plan to address potential asset price bubbles with financial supervision, rather than by raising interest rates at a faster pace than they currently expect.” In my opinion, excessive asset inflation is a result of monetary policy, not the lack of regulation. How many investors overpaying for stocks, bonds, or real estate ask, “What will the regulatory environment be like in the future?” More likely they ask, “Are central banks willing or able to raise interest rates?” Considering the prices of most risk assets, the answer to this question appears to be “no”.

Ironically, the asset inflation the Fed is concerned about and is responsible for, also makes it very difficult for central bankers to manage monetary policy in a symmetrical or balanced manner. Instead of taking the necessary action to deflate the commercial real estate boom, I expect policy makers will attempt to avoid being the catalyst for this cycle’s unwind. One of the lessons policy makers learned last cycle was asset bubbles are bad, but allowing them to pop is even worse! Considering the risks of financial instability, I believe central banks will stick with their policy of warning investors, instead of disciplining and taking corrective measures.

Is warning investors about potential asset bubbles sufficient? Warnings have done little in the past to encourage a more rational pricing of risk. Why would such warnings work today? Sometimes I wonder if warnings of overvaluation by central bankers, and even professional investors, are made so they can be used in the future as “don’t blame me, I warned you” cards.

In my opinion, warnings from central bankers do little to protect investors from asset bubbles. Furthermore, from an investor standpoint, acknowledging prices are inflated or expensive may also be insufficient. When the current market cycle ends, and if it ends badly (again), I suspect there will be numerous “we warned investors” reminders coming from policy makers and Wall Street. Warnings are nice, but what action was taken?

Rockin’ at the Clevelander

I’ve been busy over the past few days trying to catch up with earnings season. I should have a summary of dozens of small cap earnings reports and conference calls at the end of the week or early next week. As usual, I’ve found going through quarterly reports to be very helpful in determining where we are in the profit, credit, and economic cycles.

One of the reports I read today was Pinnacle Financial (PNFP). Pinnacle Financial is a regional bank based in Nashville, TN with $11.2 billion in assets. Pinnacle’s earnings report stood out given its impressive annual loan and earnings (EPS) growth, up 14.6% and 17.6%, respectively.  I remember Pinnacle, as I considered purchasing its stock during the financial crisis when it traded below book value. Given Pinnacle’s limited operating history (founded in 2000), I ended up buying a different bank, but I’ve kept my eye on their business ever since.

I don’t own banks often, but I’ll consider purchasing when they sell near or below tangible book value. Unfortunately, as an absolute return investor desperately searching for any sign of value, Pinnacle Financial is currently trading well above tangible book value. With its stock up 50% over the past year and trading over 3x tangible book, Pinnacle, along with many other regional banks, appear to be partying like it’s 2006 again. Pinnacle’s balance sheet and income statement also remind me of the last credit cycle, with minimal loan losses and assets growing rapidly (doubling over the past five years).

Pinnacle has benefited from its exposure to the city of Nashville, which is currently experiencing above average growth. According to the New York Times, Nashville’s residential growth this decade has exceeded last decade’s by over three times. Zillow recently named Nashville as the hottest housing market for 2017. Zillow’s rankings consider the region’s unemployment rate, income growth, and housing inflation. Although a recent acquisition will help Pinnacle diversify geographically, out of its top 10 metropolitan markets, the combined entity had 43% of its deposits tied to the Nashville region (per company presentation; as of June 30, 2016 and assumes acquisition of BNCN is completed).

Commercial real estate is also growing rapidly in Nashville (45% of Pinnacle’s loan mix was commercial, industrial, and construction as of 12/31/16). In October 2015, the New York Times noticed this growth and published the article, “Nashville’s Skyline Being Reshaped by Building Boom”. It stated, “More than 100 new projects, together valued at more than $2 billion, are underway in Nashville or planned to start next year, according to city figures.” An article from The Nashville Business Journal also discussed the building boom. The article included an interactive map of Nashville’s development projects. The map is called, “Crane Watch” and displays over 190 projects (with pictures) currently in development. Without being on the ground, I thought the map was very useful in getting a feel for the construction boom (link below).

The map reminded me of the building boom in Florida last cycle when I conducted my own crane watch. I drove around town identifying and taking pictures of all of the construction cranes in Jacksonville Beach, Florida. There were numerous cranes, but not nearly as many as there are in Nashville currently. The city looks similar to Miami near its peak ten years ago!

Trading over 3x tangible book value, I’ll continue to monitor Pinnacle Financial, but I won’t purchase its stock. For the sake of Pinnacle and other regional banks with rapidly growing balance sheets, hopefully this building boom and credit cycle ends differently than the last one.

Links:

Crane Watch Map

Picture of Nashville Skyline

Chart of PNFP

 

The Hatters

I attended Stetson University from 1989 to 1993. Stetson is a small college in DeLand, Florida (located between Orlando and Daytona Beach). While it was nice going to school near the beach, there were many other reasons to attend Stetson. At the time, Stetson was one of the few colleges with an investment program that provided students with the opportunity to manage real money. Stetson’s Roland George Investment Program was funded by Mr. Roland George. From Stetson’s website, “Mr. George was annoyed with colleges teaching only theory, the program he envisioned would enable students to manage an actual portfolio.”

The program was different than all of my other business courses. It felt like we were interns of an asset management firm, not college students. Instead of a professor teaching out of a textbook, an experienced portfolio manager taught us how he approached investing and portfolio management. Max Zavanelli, a small cap portfolio manager, taught the program while I attended. While most college professors were teaching efficient markets, Mr. Zavanelli taught us markets were inefficient and full of opportunity. I’ll never forget when he unexpectedly threw a $100 bill on the classroom floor. He was attempting to teach us how quickly opportunity can appear and how quickly investors need to act before it disappears. It was like throwing a loaf of bread in the middle of a flock of hungry seagulls. Chaos ensued as financially strapped students trampled over each other to lock in a potential $100 gain.

Mr. Zavanelli introduced us to many other market inefficiencies, including those created by stock buybacks. Through his research, Mr. Zavanelli discovered companies that bought back stock tended to outperform companies that did not. In the current market, when almost every company is buying back stock, this doesn’t sound like an original idea. However, in the early 90s buybacks weren’t nearly as common as they are today. According to the Business Insider article, “The Rate Of Share Buybacks Has Doubled In The Last Decade,” the percentage of companies in the S&P 500 buying back stock increased from approximately 40% in 1992 to 85% in 2014.

The benefits from buybacks, along with the information they provided, made immediate sense to me. I thought if a company was buying its stock, management must believe the equity was undervalued. Furthermore, management must also have confidence in the company’s balance sheet and ability to generate free cash flow. If management felt their future was bleak, they certainly wouldn’t be using precious capital to retire stock – their future must be bright. I was a believer. From that day forward, I searched for and gravitated toward companies that bought back stock.

While I continue to appreciate buybacks, I’ve adjusted my views and learned some valuable lessons over the past three profit and market cycles. First, as almost is always the case in investing, price matters tremendously. Early in my career, I quickly learned that companies tended to repurchase stock more aggressively during periods of elevated profits. When companies are generating healthy profits, their stocks are often trading at healthy valuations. As such, I discovered many companies bought back stock when prices were inflated. Making matters worse, they seemed to avoid buying stock when profits were in decline, but equity prices were attractive. In effect, when it came to buying stock, companies face many of the same challenges as investors, who instinctively want to chase rising prices and freeze during sharp market declines.

With 85% of the S&P 500 buying back stock in 2007, it’s clear that many companies unnecessarily overpaid near the peak of the last profit and market cycle. This leads me to an obvious but seemingly underappreciated point. Stock buybacks can be an effective use of capital if the stock is purchased below its intrinsic value. Conversely, buybacks made at prices above a business’s worth destroy value, diluting intrinsic value per share. With buyback programs and equity valuations currently near record highs this cycle, I believe it’s likely many companies are again unknowingly reducing the per share value of their businesses. In fact, at the end of the current market and economic cycle, I suspect there will be numerous companies regretting their aggressive use of stock buybacks and wishing they had their capital back.

While not all buybacks are accretive to intrinsic value per share, many are accretive to earnings per share. This is especially true in a low interest rate and sluggish revenue growth environment. With a limited number of acceptable ROIC projects, buying back stock is a relatively safe decision for mature businesses. In addition to being an easy way to enhance EPS, I believe some companies buyback stock due to pressure from outsiders. I can’t count the number of times managements have been asked on conference calls how they plan on returning capital. I believe the rise in activism has also encouraged stock buybacks. In an attempt to deter or appease activists, some companies use buybacks to intentionally weaken their balance sheets and inflate the value of their equity. While this may not be in the best interest of the business in the long-term, it can be effective in making the company appear less attractive for activists.

Given the valuations of most of the companies I follow, I’m currently not a proponent of most stock buyback programs. At this stage of the market and profit cycle, I believe many companies would be better served thinking independently when making capital allocation decisions. Instead of following the herd and buying back stock, I believe more companies should consider issuing stock. At current prices, issuing stock would be accretive to the value of many businesses. Furthermore, stock issuance would provide relief to companies that have taken on too much debt this cycle. According to the Bloomberg article, “Goldman Sachs Says Corporate America Has Quietly Re-levered,” corporate debt and net debt/EBITDA is higher this cycle than last cycle’s peak, with an increasing amount of debt proceeds going towards funding dividends and buybacks.

To be fair, some companies are issuing stock, however, most are doing so out of necessity (energy industry is a good example). An old friend and fellow Stetson Hatter made this distinction to me last week. Specifically, there’s a big difference between issuing stock to increase intrinsic value per share and issuing stock to survive. My friend also pointed out that I was mistaken regarding my belief that most companies were reluctant to issue stock. He said plenty of stock is being issued in the form of stock-based compensation and option programs. It was a good point and true.

Companies have also issued stock for mergers and acquisitions. However, similar to buybacks, most mergers and acquisitions occur when profits and asset prices are elevated. In essence, near profit and market cycle peaks, companies are often trading inflated equity for inflated equity. When a company’s stock is overvalued, instead of issuing stock for acquisitions, why not issue stock to raise capital for use at a later date? Why not wait for the next recession and acquire your leveraged competitors at attractive valuations? When the next economic and financial trough inevitably returns, I suspect few companies and investors will want equity – they’ll prefer and need liquidity. With so many balance sheets more leveraged this cycle than the last, how many companies have the ability to take advantage of future opportunity?

While I’m not expecting the craze in stock buybacks to reverse or for companies to begin issuing stock, I find the discussion interesting. Thinking as a business owner, issuing stock at inflated valuations makes a lot of sense to me. In addition to healing injured balance sheets, issuing overvalued stock can increase a company’s intrinsic value per share and provide it with the liquidity needed to take advantage of future opportunities. When the current market cycle ends, the opportunity set for investors and companies will be very different from today’s. Will investors and corporations be ready? Are portfolios and corporate balance sheets positioned for the past or the future? Given current valuations, I like the idea of being positioned for the future. I want to be ready for the next time the markets drop a crisp $100 bill on the floor.

Book Recommendation

My favorite investment book, Waiting Is Not Easy by Mo Willems, isn’t an investment book – it’s a children’s book. The elephant’s (his name is Gerald) expression on the cover says it all. It’s how many patient absolute return investors felt in 1999, 2006, and today – frustrated and exhausted! Hang in there, Gerald. You wouldn’t know it at this stage of the market cycle, but historically when equity valuations reach such heights, patience has paid.

Speaking of equity valuations, I had a constructive conversation with a fellow value investor today. We talked about valuations and profit margins. Specifically, do equity valuations make sense if margins are sustainable or increase further? It’s a good question and one I would expect at this stage of the profit, market, and credit cycles. Asked differently, has the business cycle been repealed? If we never have another recession and the drivers of the current economic cycle are perpetual, then maybe margins are sustainable and maybe profits will eventually catch up with equity prices. In such an environment, it’s possible patience doesn’t pay and stocks continue to rise indefinitely.

Of course, given my positioning, I don’t believe the business cycle has been repealed and believe there will be another recession. At that time, we should be in a better position to determine if elevated margins are perpetual. I don’t see why they would be. Margins certainly weren’t immune to falling demand at the end of the last cycle — profits plummeted along with credit-fueled investor confidence.  

Do we really need a recession to prove profits remain cyclical? I don’t think so. When viewing the profit cycle from a bottom-up perspective, it is clear that margins continue to fluctuate and remain influenced by traditional drivers such as costs, demand, competition, credit, etc. Given my belief that profits are cyclical and remain non-linear, I continue to demand an adequate return on investment relative to the uncertainty assumed. Furthermore, I’m avoiding extrapolating peak margins by normalizing cash flows in my business valuations. In effect, I do not believe this cycle is different and plan to remain true to my process and valuation discipline.

In conclusion, I’m with Gerald and plan to remain patient. I could be wrong, but I continue to believe patience will eventually pay. But Gerald is right. It’s not easy. If it was, everyone would do it. With stock prices set to spike higher again today and the Dow reaching 20,000, I’m sensing patience is the last thing on most investors’ minds these days. When it comes to investing in a world of seemingly endless asset inflation, patience is not easy, and it certainly isn’t popular.

I planned on reviewing several earnings results this week, but I’m doing some unexpected travel. Therefore, I won’t be able to post on earnings in detail until next week. My apologies.

Earnings Season Begins

I’m going to be very busy the next few weeks as the companies on my possible buy list begin releasing earnings. I’ll try to post when possible, but will most likely stick with concise company-specific posts. My goal will be to provide an overview of the current operating environment and economy through the eyes of business, not government data or top-down macro research.

As I noted in previous posts, I’m not expecting Q4 operating results to differ meaningfully from Q3. However, I believe there will be some noticeable changes in certain industries and some economic trends. For example, I’m noticing more companies mentioning rising costs in earnings reports and conference calls. So far it seems manageable, but I plan to pay closer attention — especially as it relates to the possible impact on margins and cash flows.

While many investors have celebrated rising energy prices, inflation is an uncertainty and a business disruptor – most companies prefer cost stability. Volatility in costs often equals volatility in cash flow, which increases the risk of an equity investment. In theory, inflation risk and operating margin uncertainty should already be reflected in equity risk premiums and normalized cash flow assumptions; however, with many companies currently generating near peak margins and selling near peak valuation multiples, I’m not so sure.

H.B. Fulller (FUL) is a good example. H.B. Fuller is a manufacturer of adhesives and sealants. Over the past ten years H.B. Fuller has traded between 0.6x to 1.4x EV/sales. Guess where it is trading today? You guessed it, 1.4x EV/sales. I often talk about my opportunity set being the most expensive I’ve ever seen. This isn’t a gut feeling. Many of the small caps I follow trade near record valuations, especially on a price to sales and normalized cash flow basis. Given H.B. Fuller’s elevated valuation, I question if investors are normalizing their margins, which are also near peak levels. Specifically, EBIT margins have ranged from 7.9% to 10.2% over the past ten years, with current EBIT margins are near 10%.

In addition to illustrating one of the many companies selling near peak valuation while generating peak margins, H.B. Fuller is a good example of a company facing rising costs and currency headwinds. I thought management did a good job communicating these challenges on its conference call yesterday. With 60% of its revenue generated outside of the U.S., the operating drag from a rising dollar isn’t surprising. I found their comments on rising costs a little more interesting. Specifically management noted, “We expect flat to modest inflation in the raw materials that we’ve purchased and modest growth margin pressure, especially the first half of the year as we ramp up our efforts to reformulate products, implement strategic price increases, and drive savings of our manufacturing costs to offset these raw material impacts.”
Management also touched on the shift from experiencing deflation to inflation and how that will impact comparisons throughout the year. “Now we are facing the phenomena where in 2016, we had some price decrease, but we’ll be lapping some of those the first half of this year. So we had some decreases the first half of this year, really none in, I would say, the last four or five months, and an increase is kicking in at the end of this year and we will see some of those continue this year. So I would say the net net next year will not be some sizable uptick but you will — you won’t see this downtick going forward.”

In effect, H.B. Fuller is explaining what many in the bond market have already discovered. The days of investors “worrying” about deflation appear to be numbered (worrying = driving global bond yields to record lows and equity prices to record highs). In my opinion, the tide has turned as more companies shift their focus on how to manage in a rising cost environment.

There’s a lot more to discuss, but it’s Friday and Inauguration Day, so I’ll keep it short. Next week I hope to provide an update on consumer companies. Have a great weekend!

Normalizing and Scenario Analysis

A reader commented yesterday on the market’s CAPE (cyclically adjusted P/E) and how it has not been a good indicator of future returns over the past five years. He has a good point. During market cycle booms, inflated valuations are often ignored. It isn’t until after the cycle ends that it becomes obvious valuations reached unsustainable and unjustifiable levels. When that occurs this cycle is pure speculation and unknowable, in my opinion.

While valuations aren’t extremely helpful in determining the near-term direction of stock prices, I believe they can be useful in estimating potential gains or losses that can occur when cycles revert from market extremes. For example, at 28x normalized earnings (Shiller P/E), equity investors would lose approximately half of their capital if valuations reverted to a 7% normalized earnings yield. Sound unreasonable? Imagine a world with Treasuries yielding 3%-4% and corporate bonds yielding 4%-6%. In such an environment, a normalized earnings yield of 7% doesn’t seem too unreasonable to me — it actually fits nicely.

Every CAPE is created differently as every cycle is different. The market cycle in the late 90s and early 2000 eventually reached a Shiller PE exceeding 40x. Investors often point to this valuation to indicate that maybe today’s 28x isn’t so outrageous. I’d argue the late 90s cycle was VERY unique. The largest weight in the S&P 500 was technology (34% weight in early 2000). Many of the technology stocks then had a lot of “P” but not much “E”, skewing many of that cycle’s aggregate valuation measurements. The tech bubble was extreme, but narrow. Today’s market cycle is very different as asset inflation is much broader. In my opinion, taking comfort in the tech bubble’s inflated CAPE is misguided as the cycles simply aren’t comparable.

Although informative and helpful in determining the potential risk/reward of the overall market, I rarely use aggregate valuation measurements when allocating capital. The majority of my investment decisions are based on individual business analysis and valuation. Nevertheless, similar to how CAPE is calculated, I like making cyclical adjustments to companies’ earnings and cash flows. I believe normalizing is especially important when valuing cyclical businesses. My process is simple, but as often is the case, I prefer flexibility over rigid rules.

Many cyclically adjusted measurements use a ten-year average. From a bottom-up perspective, I prefer customizing my time frame. A ten year average makes sense if the company’s profit cycle is ten years, or two five year cycles. But what if the ten year period includes two up cycles and one down cycle? This could lead to an inaccurate normalized cash flow assumption and ultimately an inaccurate valuation.

Below are two cyclical companies:

EPS of Company A*

2006  2007  2008  2009  2010  2011  2012  2013  2014  2015

3.94    2.77   2.36  (0.20)  0.78   2.10   1.99   1.31   1.13  (2.05)

EPS of Company B*

2006  2007  2008  2009   2010  2011  2012  2013  2014  2015

2.51   2.15   1.97   (1.83)  (1.53)  1.01  1.71   1.11   1.47   1.27

While both companies are cyclical, they have different profit cycles (degree and duration). Furthermore, both cycles are shorter than ten years. Company A appears to have two profit cycles over this ten year period, while Company B has one and a half cycles. The companies are also in different industries. Company A is Patterson-UTI Energy (PTEN) and Company B is Ethan Allen Interiors (ETH).  Patterson’s results are correlated to the energy industry (onshore drilling), while Ethan Allen is correlated to housing and discretionary consumer spending.

On an unrelated topic, I always find it interesting that some investors will avoid cyclical businesses like Patterson as they’re “commodity related” but are very comfortable investing in other cyclicals, such as Ethan Allen (classified as a “consumer” company). I don’t really have a point or strong opinion, I just find it interesting how some investors are willing to accept the cyclical nature of certain industries (such as tech and consumer), but not others (such as commodities and industrials). Another topic for a future post.

I recently worked on Ethan Allen as a possible addition to my buy list. They recently preannounced lower than expected earnings and its stock declined considerably. During my due diligence I discovered an interesting and informative slide in one of their presentations (link below). It was a slide that acknowledged their business was cyclical and provided investors with a scenario analysis. The probabilities of their scenarios are debatable, but I thought the slide was a good example of how I like to normalize cash flows. Specifically, instead of using a simple 10-year historical average, I prefer using scenarios with a variety of revenue and margin assumptions.

Slide 101 of 110:

http://media.corporate-ir.net/media_files/IROL/81/81552/ETH_FINAL_MFK_SHAREHOLDER.pdf

*The EPS data in today’s post was provided by Sentieo. I’d like to thank a reader and Sentieo for getting me set up with a trial. There are alternatives to Bloomberg — thankfully! It’s taking me some time to get up to speed, but so far so good. I really like their “valuation and model” page. In any event, if you’ve recently lost your Bloomberg, it might be worth a look.

And That’s OK

In late 2008 a journalist called me to ask my opinion about General Motors (GM). I asked him why he was reaching out to me since my focus was on small cap stocks. He replied that General Motors was a small cap stock. I couldn’t believe it, but he was right. After losing billions in market cap, General Motors was technically a small cap stock – amazing. Nevertheless, I still didn’t have an opinion on their business or stock as I didn’t follow the company closely.

As investors, “I don’t know” is probably something we don’t say enough. While it would be nice to know everything about every investment, there is simply too much to know.  Over my career, instead of attempting to know everything, I decided to remain focused on a defined opportunity set.

My opportunity set consists of high-quality small cap stocks with market capitalizations between $100 million and $5 billion. My definition of quality is simple. I like established businesses that have operated through multiple profit cycles. The more cycles the better. Long operating histories are helpful in determining a company’s normalized cash flow. Furthermore, I’ve found that companies that have survived many booms and busts frequently possess traits one would expect of a high-quality business. Survivors often have enduring qualities setting them apart from their less fortunate peers that are no longer in business. Many companies on my possible buy list are market leaders as they’ve gained market share each profit cycle. I like growth, but growth that is sustainable or predictable. In effect, the majority of my opportunity set consists of companies I believe I can value.

One of the drawbacks of having a focused opportunity set is having to frequently say “I don’t know”. It’s not something I like to admit, but I don’t have sufficient knowledge of most companies to provide actionable feedback or opinions. For example, my friend Lawrence (he goes by Larry, but I like to call him Lawrence because he’s so smart) recently asked me about Medtronic (MDT). Medtronic has a $100 billion market cap. It’s a huge company that would take days if not weeks to properly analyze and value. While it may be a great business and investment, without doing the necessary work, it’s impossible for me to know its worth. Sure, I could give it a quick overview and come up with some nice bullet points to make myself sound knowledgeable, but that wouldn’t be fair to Lawrence. If I don’t know the business well and I’m not confident in its value, my comments could unnecessarily put Lawrence’s hard-earned capital at risk. Therefore, instead of providing him with an opinion without proper due diligence, I simply responded that I didn’t know.

Outside of my opportunity set, there are a limited number of companies I’m comfortable commenting on. In fact, I don’t know a lot of things when it comes to investing. I don’t know exactly how or when the current market cycle ends. I don’t know when valuations will matter again. I don’t know when central banks lose control and free markets return. I don’t know the next time I’ll be fully invested. And I certainly don’t know the near-term direction of stock prices. But I get asked about these things frequently. I wish I knew, but I don’t.

Acknowledging what you don’t know is also very important in valuing businesses. Measuring what you don’t know is subjective. Typically the more you don’t know the higher rate of return you should demand on an investment. This is often called the risk premium and it should be included in your discount rate when discounting future cash flows. If investors knew everything, including the future, a risk premium would not be required. Interestingly, with current normalized earnings yields similar to that of many risk-free (coupon, not price) government bonds, investors are not requiring much of a risk premium. Based on current prices, investors seem to know almost everything about the future — their crystal balls are a lot clearer than mine.

I’ve never been so certain of any equity investment that I eliminated its risk premium. There is simply too much about the future I don’t know. As Lawrence would ask, “Well then Eric, what do you know?” I know future cash flows of businesses are not risk-free. I also know my opportunity set has never been this expensive. I know if I were to fully invest today, I’d make a lot of mistakes and would most likely lose considerable capital. I know when I screen for stock ideas, the valuations on many small cap companies I analyze literally upset my stomach. I also know, that similar to every cycle before it, the current market cycle will end. And finally, I know discipline and perseverance will be essential in surviving and eventually prospering once this cycle ends and opportunities return.

Attempting to know everything is difficult and can distract you from knowing a lot about what’s important. In my case, that’s my opportunity set. In order to properly implement my process and discipline, I need to remain focused and acknowledge there is a lot I can’t and don’t know. As Stuart Smalley liked to say, “And that’s OK.”

The Art of Looking Stupid

The investment management industry is filled with thousands of extremely smart people. Top in their class smart. It could easily be argued that there is an oversupply of smart investors. Throughout their lives they’ve received accolades and pats on the back reconfirming what they already know – they’re extraordinarily smart. One thing I’ve learned over the years is smart investors – understandably – don’t like to look stupid.

While I have absolutely no data to support this, with an investment world overflowing with smart people, I believe there is a shortage of professional investors willing to look stupid.

That’s a shame as looking stupid is often necessary when practicing absolute return investing. I have a long track record that proves I’m more than willing to look dumb. There have been times when my relative performance was so bad, Bloomberg ranked it “N.A.” Embarrassing to most managers, I view my “stupid” positioning as a necessary part of my process, providing me with the ability to generate attractive absolute returns over a complete market cycle (my investment objective). As long as performance deviations aren’t due to valuation errors and permanent losses to capital, investing differently during periods of inflated valuations may not be stupid at all, but a sign of discipline, perseverance, and even intelligence. In other words, looking stupid is not the same as being stupid.

Instead of being ashamed or embarrassed, I view my ability and willingness to look stupid as a competitive advantage. If there was a market leader in looking stupid during irrational markets, I would like to think I’d be on the short list. I’m sure my current positioning doesn’t look very bright either. But this isn’t new for me. Patient positioning almost always looks questionable or unintelligent during periods of sharply rising asset prices and inflated valuations.

The secret of looking stupid, is not caring what other people think. Perception risk is a very real and underappreciated risk in the investment management industry. In my opinion, it’s one of the leading threats to investment discipline and one of the reasons so many active funds look the same as their peers and benchmarks. If you’re constantly concerned about what your boss, peers, and clients think about you and your positioning, you’ll never master the art of looking stupid.

To be clear, looking stupid indefinitely is not a smart long-term strategy. For instance, an absolute return investor shouldn’t remain patient or overly conservative throughout the entire market cycle. The goal of positioning differently, or remaining patient during market extremes, is to ultimately take advantage of the inefficiencies and distortions created by conformity and group-think. Eventually cycles end and the mispricing and extrapolation of market extremes unwind. This unwind can create tremendous opportunity, which should allow flexible absolute return investors to shift from patient to aggressive positioning. In effect, there should a period each market cycle when opportunistic and aggressive positioning is necessary and ultimately beneficial.

The purpose of looking stupid is to look smart over a complete cycle. While I’ve had some of the worst in-between cycle performance, I’ve also had some of the best complete cycle returns. To successfully look stupid and generate attractive full-cycle absolute returns, investors might consider setting their egos aside, think independently, and eliminate the importance placed on perception. Good luck!

Looking stupid isn’t as easy as it appears!

Have a great weekend. Hopefully we can start talking about some company-specific operating results soon as we enter earnings season. I’m looking forward to it.

Normalized Earnings Yield

I often like to view the ownership of a mature operating business as owning a perpetual bond. As the name suggests, a perpetual bond never matures. Similarly, a viable business with rational management and a strong balance sheet should be in existence for a very long time. A good example is a stock I owned a decade ago called Grolsch Brewery (SABMiller acquired in 2007). It was a beer company founded in 1615 – now that’s an established and mature business!

What’s nice about perpetual bonds is they’re easy to value (cash flow/discount rate = price). Valuing an established business in this manner is also simple. For instance, if a company is expected to generate $10 million in free cash flow a year indefinitely and you demand a 10% return on investment, the value of the business is $100 million (to make even simpler I assumed a 0% growth rate).

Similar to perpetual bonds, companies provide investors with cash flows. As such, they also provide investors with yields. While most equity investors focus on dividend yields, I’m more interested in the business’s normalized free cash flow yield. Over the long-term, free cash flow is often similar to net income; therefore, I believe it’s reasonable to label an equity’s free cash flow yield as its earnings yield. In the above example, assuming the business has a market value of $100 million and normalized earnings of $10 million, its earnings yield is 10%. I define normalized earnings as the average earnings a business is expected to generate annually over a full profit cycle.

For all of you valuation wizards, I apologize as I know this is all review and below your pay grade. Even though the normalized earnings yield is a very simple calculation, I believe it’s an underutilized measurement of value and potential return. When was the last time you saw a normalized earnings yield in a presentation or portfolio fact sheet? Historical returns are much more popular, but in my opinion, less valuable and informative. For example, when investors view the small cap options in their 401k plans, what do they see? Currently they see most of their small cap choices have generated approximately 15% annualized returns over the past five years. 15% a year? That will work – sign me up!!!

Instead of focusing on past performance, what if the portfolio’s current normalized earnings yield was also included? This would be very helpful, in my opinion. Let’s assume that one of the 401k investment options in the example above was a typical small cap fund or the Russell 2000. According to Bloomberg, the Russell 2000 trades at 49x earnings (unadjusted). What if instead of showing an investor that the fund generated 15% a year for the past five years, they were also informed that the fund’s holdings were only generating an uncertain 2% earnings yield? I believe including the earnings yield would raise some important questions. For instance, what is a better indicator of future returns, the portfolio’s current 2% earnings yield or the past five years of 15% annualized performance? Or maybe an even more relevant question is how does an equity portfolio generating a 2% earnings yield provide investors with a 15% annualized returns going forward?

My current buy list is trading at 30x earnings and provides a meager 3.3% earnings yield. I don’t have an aggregate normalized earnings estimate on my 300 name buy list, but I believe profit margins (on average) remain above historical levels. Therefore, normalizing earnings of my buy list stocks would most likely cause the aggregate earnings multiple to increase and its earnings yield to decrease. The Shiller P/E is currently 28.1x, or provides a 3.6% normalized earnings yield. Since 1980, the Shiller earnings yield has ranged from 2.3% to 15%. Investors who bought when the earnings yield was high did considerably better than investors who bought when it was low. Buying stocks when normalized earnings yields are high, is simply another version of buy low sell high, or common sense investing.

And that’s one of the things I like so much about the normalized earnings yield. It’s an easy to understand valuation metric that is founded on common sense. Does receiving an uncertain 3% coupon on equity investments appropriately compensate investors for risk assumed? This is an especially relevant question when the 30-year Treasury is also yielding 3%. Or when the long-term bonds (higher up on the capital structure) of many of these companies are yielding 3%-6%.

The normalized earnings yield is a very simple, but effective valuation metric. In my opinion, providing or knowing a portfolio’s normalized earnings yield would benefit asset allocation decisions that have historically been heavily influenced by past performance. If the normalized earnings yield was included alongside past performance, I believe some investors may think twice about allocating their retirement savings into such low yielding risk assets. And at current equity prices and valuations, maybe a splash of reluctance and prudence wouldn’t be such a bad thing.