Perception Risk

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

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

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

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

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

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

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

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

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

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

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

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

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