The Inflation Recognition Moment

Before I dive into the topic of the day, I’d like to briefly discuss my recent spite trade (Growth, Value, and Spite). Specifically, I closed out my Russell 2000 put position last week after making enough to pay the electric bill 🙂 . It’s another example of why I’m not a successful short seller or put option speculator. Even when I get lucky on the timing, I tend to close the position too early, making it difficult to achieve an adequate return relative to risk assumed.

Instead of short selling and timing when stocks will fall, I prefer patience and investing after prices decline and opportunities reappear. This is not meant to disparage the art of short selling. It simply means as an investor, and over many years, I’ve gotten to know my strengths and weaknesses well. Historically I’ve achieved my absolute return goals by owning attractively priced small cap stocks and holding them until my calculated valuations are reached. It’s not as exciting as short selling, but it’s a process I’m confident and comfortable implementing — it’s what has worked for me.

With my put option speculation behind me, I’d like to focus on the labor market and tomorrow’s jobs report. I’m going to take an unusual position on this all-important economic data point by stating I believe the report is irrelevant. In my opinion, the bottom-up evidence is convincing – the labor market is very tight and wages are increasing. In fact, I feel the bottom-up evidence has become so convincing, I do not foresee anything from tomorrow’s report that will alter my views. And similar to the last time I remember labor being this tight (1999), I’m not expecting a meaningful change until asset prices decline and we enter a recession. In effect, I believe we’ve reached full employment this cycle and will remain here until the next cycle begins.

As we proceed through this cycle’s phase of full employment, I plan to continue to monitor the labor market through my bottom-up lens, with particular interest on wage gains and labor availability. In addition to monitoring the labor market through the analysis of my opportunity set, I’ll continue to accumulate anecdotal evidence and other real world examples. Some of my favorite labor market examples and updates come from reader emails.

Below is an email from an experienced investor who understands the economy and financial markets well. His recent experience while staying at a hotel emphasizes a topic that is becoming increasingly important for many businesses (especially for those attempting to grow) – labor availability.

He writes, “There were two stories that I felt I had to share. First involves our hotel. Despite having made reservations 6 months in advance, none of our rooms were ready upon arrival. We waited into the night when some families just offered to take their rooms as is so they could get some rest. The poor staff was nice enough about it but they simply didn’t have the bodies to clean rooms. Some creative manager had a brilliant idea at checkout though. They offered rewards points to guests who would clean their own rooms upon leaving!”

If reward points in exchange for customers cleaning their hotel rooms isn’t a sign of a tight labor market, I’m not sure what is! His other encounter with insufficient labor came while visiting a local pizza shop. Again, it’s not just about wages, it’s about labor availability.

“On that same trip, we went to a local pizza place for dinner one night. One of the parents was talking about how his folks had owned a pizza place when he was a kid. One of the servers overheard the conversation and offered us all the beer we could drink if this guy would jump over the counter and help make pizzas. After the rest of the place had cleared out the server/manager explained that she was on the verge of losing all of her employees as everyone was massively over-worked and they simply couldn’t find help.”

Another reader sent an article about a convenience store chain in Texas called Buc-ee’s. The company hangs a board advertising its positions and wages in its stores (see picture in article: link). It’s a good article illustrating how companies are aggressively competing for labor and being forced to pay wages well above state minimums. For example, the minimum wage at Buc-ee’s starts at $14 an hour versus Texas’s minimum wage of $7.25 an hour.

As Q2 earnings season approaches, I will be monitoring business labor and wage trends closely. Based on Q1 operating results and earnings reports released in June, I believe the labor market remains tight. While tomorrow’s jobs report will not alter my views, I’m well aware many investors will be paying very close attention. And I suppose even I’ll tune in to learn if tomorrow’s report will be the catalyst that causes investors to finally acknowledge wages and inflationary pressures are rising. I call it the inflation recognition moment. What exactly causes it remains a mystery, but barring a sharp decline in asset prices, I’m expecting and prepared for its arrival.

Style Boxes: Growth, Value, and Spite

It’s been two years since I recommended returning capital and interrupted my eighteen year track record. Although it was a difficult decision, in hindsight it appears to have been the right course of action. Since 2016, valuations have become even more expensive, making it challenging to find a sufficient number of undervalued equities to build an absolute return portfolio. Furthermore, while I worked with very sophisticated clients who understood my process well, holding an equity fund invested in T-bills would have been difficult for most advisors and consultants (especially over the last two years).

I never intended to recommend returning capital and go all-in on patience. My long-term goal was to manage an absolute return fund through as many market cycles as possible. However, the broadness of this cycle’s overvaluation, along with my determination to remain disciplined, caused me to pull myself out of the game. And of course I remain out of the game and on the bench today (literally – as I write this I’m sitting on a bench at Starbucks next to a guy trying to sell commercial real estate loans 🙂 ).

During my final days of employment I had some time to reflect on my career and decision to recommend returning capital. I remember staring out my office window wondering if I made the right career choices. For most of my adult life my dream was to be an equity analyst and portfolio manager. And there I was, sitting alone in an empty office, days away from giving it all away.

Despite some initial regret and second guessing, deep down I knew it was the right move, or the only move. It was unfortunate, but as an absolute return investor, it’s what I signed up for. When getting paid to take risk, you take it and when you’re not, you don’t. It’s pretty simple and straightforward – never, ever, knowingly overpay, especially with other people’s money.

There are other things I remember about my final days at the office. I remember putting together an unemployment checklist, or things I wanted to accomplish and avoid during my time away.

First on my list was “stay busy”. I’m typically happiest when busy. To keep my mind active, I made a commitment to continue following my 300 name possible buy list and maintain my absolute return process. Furthermore, I decided to start a blog as a way to stay involved in investing, organize my thoughts, and document the profit and market cycles through the eyes of operating businesses. Throw on the additional duties of Mr. Mom and Uber Parenting, and I have far exceeded my goal of remaining busy.

Other items on my checklist include what you’d expect, such as: spend more time with the kids, clean and organize the garage (oops), exercise, avoid ice cream, avoid financial television, reduce expenses, and detox from the markets.

And finally, at the end of the list was a directive related to investing personal funds. I must have thought it was important as it was the only item on the list underlined and made bold. It said, “Do not short or buy put options!!!”

My advice to myself came from experiences I had with individual stocks and the markets over the past twenty-five years. During this period I learned important lessons related to valuation and its usefulness in timing asset prices. Specifically, while valuation is very effective in determining future returns, it provides little information on when those returns will be realized. In effect, knowing an investment is undervalued or overvalued tells us little about when the price of the investment will converge with its underlying value.

As the past three market cycles illustrate, asset prices can remain mispriced for many months and even years. Furthermore, as we experienced with the tech, housing, and “The Third Time is the Charm” bubbles, overvaluation is often an insufficient deterrent for investors determined to chase prices higher and higher. Therefore, while shorting overvalued assets makes sense to me intuitively, the risks associated with crowd psychology and the ineffectiveness of valuation-based shorting keep me away.

The decision to avoid shorting is not as easy as it sounds. As an investor guided by valuation, there is a natural desire to take advantage of asset mispricings. Furthermore, sometimes it just feels good shorting an overvalued stock or market. The feeling is difficult to explain, but resembles a sense of satisfaction that comes with voting against something irrational or something you don’t believe in. I call it spite investing.

While spite investing may feel good, there is a reason spite investing is not an investment category, style box, or ETF. Spite investing tends to be emotional and often requires precise timing to incur a profit – something I haven’t mastered. In fact, I have put options on tech stocks (1999) and homebuilders (2006) that expired worthless to prove it!

Today’s market, in my opinion, is filled with overvalued equities and potential spite trades, making it very tempting to short the high-flyers. However, for the most part I have stayed true to my goal of refraining from shorting and buying put options. That said, from time to time this cycle, I’ve fallen off the wagon and bought a very small amount of put options (nothing consequential) out of spite. Last week was one of those times.

As a result of a rotation into small cap stocks, the Russell 2000 exceeded 1700 last week (another all-time high). It’s my understanding the rotation is based on the belief small cap stocks will perform well during a trade war. While I’m not an expert in the asset allocation game, I’d be very reluctant to pay 73x earnings, 38x median earnings, and 18.9x EV/EBITDA (ex-financials) in an attempt to profit from a trade war. In fact, the belief that small caps, at today’s prices, are some sort of safe haven was too much for my mind to overcome. We all have a breaking point, right? As such, last week I implemented a small spite trade and bought puts on the Russell 2000.

As most of my spite trades end, I will not be surprised if I realize a loss on my put options. Incurring losses and investing on emotion are mistakes absolute return investors are expected to avoid. Even knowing this, I must admit, there’s a unique sense of satisfaction that comes from voting against the madness of crowds. Spite investing may not be smart, disciplined, or profitable, but it in very small doses, it sure can feel good!

The Investors Podcast

I recently joined Preston and Stig of The Investors Podcast for another discussion on small cap stocks, the current operating environment, and my absolute return process. I even mentioned a stock I’m considering for purchase! While I got the company right (Alamos Gold), I gave the symbol for another company on my possible buy list, Alamo Group (ALG). My apologies. The symbol for Alamos Gold is AGI, not ALG. Following 300 companies is like having 300 kids…sometimes you get their names and symbols mixed up! 🙂  For what it’s worth, I’ve owned both Alamo Group and Alamos Gold in the past and like their businesses; however, I do not own either currently. In any event, I really enjoyed our conversation and hope you will as well.

The Investors Podcast

Free College $$$ and Rising Average Prices

While driving to the office (Starbucks) last week, I noticed a McDonald’s sign advertising their new tuition assistance program. I thought it was interesting so I took a picture.

Yesterday I noticed the same sign, but its message was changed from “tuition assistance” to “free college $$$”. Hopefully the new wording is more effective in attracting potential employees. “Free” certainly sounds more enticing than “assistance”! 🙂

McDonald’s isn’t alone in offering tuition assistance. College aid is becoming an increasingly popular recruiting tool in today’s competitive labor market (Forbes article).

As companies roll out new and creative ways to attract employees, the gap between the labor market (extremely tight) and monetary policy (extremely loose) appears to be growing. This raises the question, where are all of the “Fed is Behind the Curve” articles?

Similar to many economists, I suppose journalists are also very dependent on government data when reporting on the economy. To be fair, I recently read several articles highlighting wage inflation and the difficulty companies are having finding sufficient labor (Perks for Plumbers and Bad Inflation).

While it’s encouraging wages and benefits are increasing, I believe it’s important to understand how corporations are responding (who pays?). Based on my observations of business results and outlooks, I expect higher corporate costs will be partially, if not fully, passed on to the consumer.

Recent consumer business operating results support my belief, with many companies reporting higher average unit prices and checks. Furthermore, I believe the decline in promotional activity I discussed in “Peak Promotions” is becoming increasingly apparent, along with lower inventories and higher full-priced sales. In effect, many consumer companies are choosing protecting margins over growing market share and traffic – good news for profits, bad news for consumers.

To help illustrate, below are several examples of consumer companies reporting higher average prices and lower promotional activity (my emphasis).

McDonald’s (MCD): Sales were fueled by higher average check, driven by two primary factors; menu price increases as part of a broader strategic pricing reset of the menu board, and favorable shifts in product mix, consisting of trade-up to new premium products and a higher number of items per order for $1, $2, $3 Dollar Menu transactions.”

Despite negative guest traffic, U.S. “operating margins increased 50 basis points to 15.8%, driven by positive comp sales, a lower advertising contribution rate, and refranchising activity, which helped us overcome higher wage rates and commodity costs this quarter.”

Cracker Barrel (CBRL): Cracker Barrel comparable store restaurant sales in the quarter increased 1.5% as average check increased 2.8% and traffic decreased 1.3%. The increase in average check reflected menu price increases of approximately 2.5% and a favorable menu mix impact of 0.3%.

Macy’s (M): Total transactions were up 1% in the quarter, with average unit retail up 5% and units per transaction down 2%. This increase in average unit retail reflects the higher regular price selling and distorted growth in our strategic businesses like fine jewelry, dresses, handbags and furniture. Additionally, as a result of having significantly less and also much fresher inventory this year, there was less selling in the quarter of deeply discounted clearance merchandise.

Gross margin as a percent of net sales for the quarter was 39%, up 70 basis points over last year. We benefited from the much improved inventory position during the quarter, and we ended the quarter with 5% less inventory on a comp basis.

Dollar General (DG): During the first quarter, we delivered 2.1% same-store sales growth, driven by fundamental improvement in customer productivity as illustrated by increases in both average units and dollars per basket.

While it’s always competitive in discount retail, we continue to see rational pricing activity across the industry.

Gross profit as a percent of sales was 30.5% in the first quarter, an increase of 17 basis points. This increase was primarily attributable to higher initial markups on inventory purchases and improved rate of inventory shrink.

Stein Mart (SMRT): Our average unit retail prices increased significantly during the quarter, driven by higher regular-priced selling but were offset by the impact of lower clearance selling.

Hibbett Sports (HIBB): So we’re selling less clearance product, more full-price product, which is helping leverage on freight cost and certainly on product margin.

Foot Locker (FL): Average selling prices in footwear were up, while units were down. In apparel, both ASPs and units were up, reflecting our customers’ steadily increasing demand for our more premium assortments.

Using constant currencies, inventory decreased 7.1% compared to a 1.5% sales decrease.

Shoe Carnival (SVCL): Traffic for the quarter declined mid-single digits while conversion and average dollars per transaction were up low-single digits. We ended the quarter with inventory down 1.6% on a per store basis.

Kohl’s (KSS): The comp sales increase was driven by an increase in average transaction value resulting from a strong increase in average unit retail. Transactions were relatively flat for the quarter.

Our inventory initiatives resulted in inventory per store decreasing 7% and our AP-to-inventory ratio increasing 195 basis points to 39.0%.

Ralph Lauren (RL): For fiscal ’18, revenue per SKU increased 16% and gross profit per SKU was up 22% to last year.

Our 4 key initiatives are delivering higher AURs, lower discounts, expanded gross margins, higher inventory turns and significant growth in free cash flow.

Dick’s Sporting Goods (DKS): Product newness, strength in our private brands and a more refined assortment led to a much healthier business, with fewer promotions and cleaner inventory throughout the quarter.

Importantly, during this first quarter, our inventory levels declined 3.8% year-over-year compared to a 4.6% increase in sales. This reflects better execution and translates to better merchandising margin rates.

I think the majority of the inventory has been cleaned up, which we talked a little bit about in the last call. So that’s been cleaned up. I think there’s been less promotional activity out in the marketplace from some of our competitors as they’ve gotten their inventory more in line.

Big Lots (BIG):  So we certainly are seeing some of the prices in key categories being very competitive. But we’re also seeing in some cases, in certain commodities that where prices are going up, retails are also going up.

Lowe’s (LOW): As a result, we delivered first quarter comparable sales growth of 0.6%, driven by a 4.3% increase in comp average ticket. However, spring has finally arrived, and comps in May are double-digit positive.

DSW Inc. (DSW): And after 2 years of inventory destocking, we’re beginning to see the benefit of a more productive inventory position. Our key item program drove a higher regular price mix and gross margin improvements.

Lumber Liquidators (LL): The overall 2.9% comp growth was affected by average ticket expansion of 4.7% and traffic declines of 1.8% [partially due to mix].

Vitamin Shoppe (VSI): Product margin improvement represents a strong sequential improvement from the fourth quarter and we’re continuing to see benefits in the second quarter as we continue to improve our pricing and promotion mix.

In conclusion, as wages and benefits increase, consumer companies are not sitting idle watching margins contract. In fact, in some cases margins are actually rising as companies reduce promotions and increase average unit prices. Barring a sharp decline in asset inflation, or the economy, I expect current trends in pricing and promotions to continue. While I don’t know to what extent government inflation data will pick up these trends, I remain uninterested in being long duration (in equities or bonds) in a market increasingly susceptible to an “inflation recognition” moment.

Participation Trophies

Whoever said “You throw like a girl!” has obviously never been to a fastpitch softball game. I’ve attended many and have seen ten-year-old girls throw 50 mph fastballs from a close distance. It’s very impressive and very challenging for those at the plate. My daughter is one of the lucky players who gets to hit these fast balls. Although it’s been a significant time commitment for our family, I’ve thoroughly enjoyed watching her, along with her team, play and grow together.

Organized sports has come a long way since I was a kid. When I was growing up, the atmosphere was more like what you see in the movie The Bad News Bears. It was less formal and much less serious. Today many coaches are paid and there are a plethora of clinics and lessons to improve all the different skill sets. Organized sports, or travel ball, has turned into an industry. I call it the youth sports arms race. To grow, industry participants simply tell parents how much talent their kids have, and boom, we’re all in line signing up for lessons and new equipment! It’s not a bad business model 🙂

I could write several posts on the pros and cons of travel ball, but for now I’d like to talk about a recent exchange I had with my daughter. This is her team’s second season. Last year they were young, inexperienced, and lost most of their games. This season, they’re older and much more competitive. In fact, they recently won a tournament, with each player receiving a large gold – ok, possibly plastic – trophy.

After returning home, my daughter walked into her room and placed her trophy on her dresser, separate from the trophies on her bookshelf. I asked why she placed her new trophy away from the others. She looked up at me and said, “Because this one matters.” It was at that moment I realized her bookshelf was filled with participation trophies, or trophies received for simply showing up. I was proud of my daughter – she understood the difference between accomplishments that were earned versus provided.

The idea of participation trophies made me think of today’s prolonged market cycle. I can’t help but wonder how much of the current cycle’s gains were earned versus provided. With interest rates pegged at 0% and global central banks buying trillions of assets, all most investors needed to do was show up, buy an index fund, and receive extremely generous returns on their capital. For almost a decade, relentless asset inflation has consistently reinforced investor behavior and decision making – yes, you are a good investor, yes, you are a talented investor, here’s your trophy (above average returns with below average risk). Don’t forget to sign up for next season!

While showing up has been a very profitable strategy over the past decade, I believe the investment environment is changing. After reviewing Q1 2018 operating results, it’s becoming increasingly clear to me that the economy and labor markets are tightening. While the current economic cycle has been anything but traditional, it’s beginning to feel more and more like an environment in which many past cycles have matured and ultimately ended.

As investors celebrate elevated corporate profits and equity prices, I believe we may be approaching a point when further gains in the economy and asset prices become counterproductive. For example, additional gains in stocks and economic growth may amplify many of the late-cycle inefficiencies that are becoming increasingly noticeable in quarterly earnings reports and conference calls.

In my opinion, the days of unlimited investor participation trophies is over – going forward, there will be winners and losers. In fact, we have seen this with stocks and bonds over the past year, with stock prices increasing and many bonds declining. Based on my bottom-up macro observations and analysis (where we are in the cycle), I believe this relatively new and uncooperative relationship between stocks and bonds is likely to continue.

As a patient investor waiting for change, it’s been refreshing watching the bond market move freely again, with the short-end of the yield curve rising sharply over the past year. The 6-month T-bill is currently yielding 2.06%, up 100 bps from a year ago. Meanwhile, the 2-year USTN currently yields 2.48%, up 118 bps over the past year. After years of earning practically nothing, yields near the short-end of the curve are beginning to look much more attractive; especially relative to normalized earnings yields on equities (near 3%).

When I decided to go all-in on patience, I was hoping to eventually be rewarded with a more advantageous opportunity set in small cap stocks. To my surprise, my reward hasn’t been lower small cap prices, but higher yields on short-term T-bills and Treasuries. And while Mr. Market’s offering of higher rates wasn’t the perfect gift, I’m encouraged by the reemergence of late-cycle trends in the economy and bond market.

In conclusion, while I currently have no exposure to equities, I’m enjoying the recent increase in short-term interest rates. I’m hopeful patience continues to pay in the form of higher rates, and ultimately, end of the cycle opportunity. When the current cycle finally ends, I suspect many of the participation trophies handed out over the past several years will lose their shine. For me, the trophy awarded for full-cycle returns has always mattered more.

_____________________________________________

Also in today’s post…a summary of Q1 2018 business trends I noticed during my quarterly review process (300-name possible buy list). I planned to send this out earlier, but had some unexpected travel this month. My apologies.

  • Inflationary pressures grew. I began to notice the shift from 2015-2016’s disinflation to inflation in Q2 2017. Each quarter since, rising corporate costs have become more noticeable. Discussions of reacting to higher costs via price increases have turned to action. Further price actions were also discussed and are in the process of being implemented (typically companies try to limit price increases to once a year). Other actions to protect margins, such as less couponing/promotions and lightweighting, also mentioned. Higher average selling prices very noticeable with many consumer companies.
  • Labor availability is becoming a growing concern – regardless of wages. Overtime mentioned. Capacity constraints was also discussed more frequently – relatively new topic. The economy appears to be tightening from labor and capacity perspective.
  • Adverse weather was mentioned frequently in Q1. On average weather was disruptive and reduced demand, especially relative to a year ago. A slight weather related bounce in Q2 would not be surprising. Business trends improved in May post poor weather. If there is a weather rebound, and it’s picked up by govt data, I’d expect to see improvement in June reports.
  • Freight costs increased substantially during the quarter. Capacity is becoming a growing issue. Companies being forced to pay spot prices for transportation are seeing very large increases in cost. New trucking regulations (electronic logs), in addition to driver shortages, are contributing. Demand strong as well. Does not appear to be a one-quarter issue – as long as demand is there.
  • Consumer companies sales trends improving on average. The promotional environment remains elevated in certain subsectors; however, deep discounting is less widespread with more full-pricing noticeable. Inventories are in good shape and fewer clearance sales mentioned. Bankruptcies continue, but some signs survivors are beginning to benefit from competitor closures. Higher average ticket noticeable for many retailers and restaurants. Weather hampered some results, but commentary suggest improvement in May. Tourism spending appears to be improving as well. QSR subsector is an exception – continues to promote aggressively and appears to be suffering from overcapacity.
  • Industrial businesses continue to perform well on average. Construction and aerospace strong. Material costs rising and pricing being passed on. Steel prices and tariffs a growing concern.
  • Energy continues to rebound. Capital available. Rig count up 30% year over year. Q2 should be strong. Labor costs and availability could become a growing issue as industry ramps up. Furthermore, it remains to be seen if the industry will drill within cash flow, or grow in excess. The energy industry’s growth is spilling over into other industries. It’s moved from a headwind to a tailwind for the economy. Permian booming. Offshore may finally be bottoming; slow improvement expected.
  • Auto slightly down. Little change expected with estimates for small decline in auto production in 2018.
  • Agriculture stabilizing, but concerns as it relates to tariffs mentioned.
  • Financial industry is performing well, on average. Bank loan and deposit growth healthy with low losses (as one would expect at this stage of the credit cycle). Credit remains easy, on average. Small caps continue to find capital; junk bond market also open for business.
  • Insurance industry tone improving. Premium pricing has firmed from declining to flat/increasing slightly. Despite increases in underwriting losses in 2017, there remains excess capital in the insurance industry. Interest income improving.
  • Technology results were mixed.
  • Currency, on average, was a positive for most businesses. Some companies noted currency increased international costs.
  • Housing and construction is strong. Labor availability and cost remains an issue to meeting demand. Homebuilders average unit prices increasing high single-digits. To date, higher interest rates have not slowed construction. Managements credit tight labor market and healthy wage gains. Weather was a drag in certain regions. Backlogs strong.
  • New tax law mentioned frequently. Sentiment is positive; however, few companies could point to specific examples of how the new law has increased demand – still too early to quantify.

Jesse Felder Podcast

Jesse Felder and I recently completed another podcast. Our discussion was focused on rising corporate costs and growing signs of inflation. In my opinion, inflation remains a difficult and unpopular topic to cover.  The bulls don’t like it as it interferes with the “rates will remain lower for longer” theme. Meanwhile, many of the bears don’t like inflation as it conflicts with the viewpoint that “the economy is weak and there’s too much debt” (both deflationary).

I’d like to thank Jesse for shedding light on what I believe remains a contrarian view — inflation is trending higher and does not appear transitory (at least until asset prices crack). I hope everyone enjoys our conversation!

Jesse Felder Podcast

 

Inflation — Subsiding or Accelerating?

Recent government reports (April jobs report, PPI, and CPI) suggest inflationary pressures may be subsiding. Meanwhile, many businesses continue to report rising wages, costs, and pricing. Who should we believe? That of course is up to each investor.

Many investors, economists, and policy makers depend on government economic data to form their macro beliefs. Personally, I prefer viewing the economy through the eyes of business, or from a bottom-up perspective. Regardless of how you develop your macro opinion, I thought it would be interesting to review what many of the companies I follow are saying about inflation.

Below are several examples of rising costs and pricing actions I gathered from my quarterly earnings review process. There are more, but I wanted to keep it concise 🙂

W.R. Berkley Corp (WRB): So, inflation from our perspective is clearly the topic of the day, I think it is the topic of the day across many industries and the insurance industry is certainly included in that. I think for some, it is a moment that people have been speculating or waiting for some extended period of time and it is upon us. Some of the obvious questions are how much, how quickly is it going to get here and how long will it stay. Obviously from our perspective there is – the impact that will come along is with a rising interest rate environment.

AptarGroup (ATR):  Look, I think everybody who is following the current environment sees inflationary pressures coming. And there is no way to escape that.

…we are recognizing increasing inflationary environment in the US and in Europe and are implementing price increases in the coming months in addition to our normal resin pass-through mechanisms.

But clearly these price increases will happen, and that’s just the current reality.

Fastenal (FAST): …as you all know, there is a meaningful inflation going on in our business.

In the local fastener business, we are seeing inflation in that product. Unfortunately, in that business, we’re not matching the inflation in our sale price. And we gave up about 130 basis points of gross margin, 130 to 140 in that 15% of our revenue. That’s disappointing and that’s a habit. And that’s a habit we need to fix. 

But, we did nice job growing the business. I challenged them on our fastener pricing at the local level. I challenged them on our freight that we charge at the local level. Fuel prices, as you all know are going up, and that impacts us like it does everybody else.

Our labor costs continue to rise.

I believe your propensity to charge freight in this environment goes up because every time I turnaround, I read an article about folks can’t add trucks and drivers and capacity fast enough. And so, freight is becoming more expensive and we were structural advantage there and we need to price for that.

United Natural Foods (UNFI): While we did leverage our expenses against our strong topline growth, we continue to have higher labor expenses in several of our distribution centers that are capacity constrained.

Additionally, our inbound freight rates have increased incrementally during the quarter, driven primarily by market supply constraints.

That the transportation industry is under a lot of pressure, capacity is scarce. The labor market is difficult. And we’re prepared to move forward in the back half.

Hubbell (HUBB): As you know, we’re targeting offsetting material cost increases with price, but typically with a three to six month lag.

So that’s the – you can’t with this much inflation, you can’t catch up overnight, but you got to be vigilant and really be disciplined about it. And so, I think it is, I think it will take us the whole year to fight that battle.

RPC Inc. (RES): Everyone pretty famously knows about shortages of skilled labor and employment issues. We think that’s just caused some friction throughout the oil field.

Forward Air (FRWD): Because you can have all the equipment in the world, but if you don’t have a fanny to put in that seat, it’s of no value. So we really are focused on drivers. I think if you talk to the most of the companies in the business, they’re focused on drivers and not on trucks.

Casey General Store (CASY): The average retail price of fuel during this period increased over 13% to $2.40 a gallon compared to $2.12 from the third quarter last year.

Darden Restaurants (DRI): Restaurant labor was 130 basis points unfavorable last year due to several factors…we continue to see elevated wage inflation of approximately 4%

…in January, we announced the $20 million investment in our workforce this fiscal year…

the real change that we’re seeing, as we analyze the benchmarks is that the check average appears to be growing and has picked up some steam.

The one place we are seeing a little bit of inflation in the food is on the distribution side. It’s getting a little bit tougher and tougher to find people to drive trucks. So, we’re seeing a little bit of distribution expense, but that’s driven by labor, not necessarily the food cost.

We’re still seeing in the 4% to 5% wage inflation.

Kirby (KEX): In the inland marine transportation business, we saw a positive change in market dynamics during the quarter. Spot market pricing increased approximately 10% to 15%

Tree House Foods (THS): Everyone is talking about how tight the freight market is right now. Not only are freight costs continuing to increase with no sign of short-term relief, but we’ve also seen our carrier acceptance rates decline about 25% over the last year. Declining acceptance rates forced us into the spot market, so it is critical that we become the customer of choice for our carrier partners.

If you’ll remember, commodities and pricing for commodities is something we started talking about with you last November. Our teams did a nice job getting after it and the remainder of that pricing will show up in Q2.

I think what we’re seeing is you can’t dodge these commodities, everyone is facing them.

So, I think we’re in an environment where most people are seeing the same kind of pressure. We have seen a number of customers, when confronted by what is a material amount of pricing, put us out to bid to check the market. But I think that’s just sort of prudent reaction to what’s really been the first across-the-board pricing for many years of this company and in the industry, I think.

Patterson UTI (PTEN): Average rig operating costs per day were also higher-than-expected at $13,970, due primarily to higher-than-expected labor cost….

Sherwin Williams (SWW): We did see an acceleration of raw material cost increases in our first quarter, and it predominantly impacted our Performance Coatings Group. And as you can imagine, when they go up that quick, it’s very hard for us to react and put another price increase into the market. That being said, we do have pricing implemented…if we see another increase that warrants a price adjustment, we’ll do that. So pricing actions are in progress.

Briggs and Stratton (BGG): …like many manufacturers, we have experienced fairly significant increases in freight rates beginning in calendar 2018. The availability of trucks has struggled to keep up with demand subsequent to the launch of electronic driver logs this year.

Higher commodity costs were offset by pricing increases

Chipotle (CMG): Comp sales were driven by higher average check, primarily from the price increase taken since Q1 of last year. The price increases averaged about 5% across the menu…

Labor costs for the quarter were 27.8%, 90 basis points higher than last year. Wage inflation of 5%

Labor is kind of the same story in terms of wage inflation continues. We expect it to continue

Steelcase (SCS): Back in the fall, we took a decision based on inflation we have seen through that date to initiate a pricing action in February. And since then, we have seen inflation up through the February price adjustment and after the February price adjustment up through just a week or two ago we have seen even additional inflation…that last piece of inflation is what we are going to start to feel more significantly in the second quarter.

We know with our customers that the best time to talk about the price adjustment is when you have inflation and we have inflation right now.

MSA Safety (MSA): We’re seeing some of the shipping expense going up slightly. There’s a little bit on our material cost, some increases there. But we’re doing a nice job from a pricing standpoint and managing that and we’re very mindful of that.

We talked about a supply chain, some supply chain issues. So those orders came in late cycle in the fourth quarter. We were caught a little bit off guard with one of our suppliers not being able to ramp up quickly enough for us

…we have rational competitors in the market place and we believe that as we see some increases we’ll pass some of those along and maintain our margin profile as we go forward.

We’re starting to see a big of wage inflation and so we’re taking a really close look at price increases in ways that we can mitigate an offset that inflation in our business.

I think the bigger trend to watch is inflation which Nish’s has talked about…inflation and what we’re seeing with the cost increases in certain areas of our supply chain and raw materials, electronic components, high density polyethylene.

Union Pacific (UNP): 5% improvement in average revenue per car drove a 7% increase in freight revenue.

In some of the more challenging labor markets, we are currently offering signing bonuses to make these jobs more attractive,

Domino’s Pizza (DPZ): Yeah, Chris, so just on food basket inflation, we’re still anchoring to the 2% to 4% for 2018, but what the stores in the U.S. will experience lines up pretty much with what we’re seeing in the rest of the industry.

As far as delivery cost of the supply chain system that we have, we were pressured in Q1 on some labor and delivery costs.

As you know, there are places that we’re at that have some pretty significant minimum-wage pressures, other regulatory pressures, that are a real headwind for the business.

HNI Corp (HNI): We are seeing higher than expected input costs across the board. As Stan mentioned, we are working to offset these pressures with additional cost savings and price increases. These higher costs will have a negative impact on the remainder of the year, particularly in the second quarter.

So we put price increases in January for the inflation that we knew about at that time for the majority of the business. And we’re also putting a secondary price in for the back half to compensate for this recent round of inflationary pressures we’ve seen.

The inflation is the big bet, and we think we have a good perspective on inflation going forward. But I think anybody who’s following the economy is trying to figure out exactly where will inflation settle out.

Convergys (CVG): We see wage pressure. We have seen some wage pressure in Europe that we have been pretty effective at addressing through working with our clients and then working with our teams in the region to do that. We have certainly seen some wage pressure in the U.S.

CH Robinson (CHRW): First, we are in a unprecedented freight environment. The healthy economy and rapid growth in e-commerce is driving a significant increase in the demand for freight. At the same time, driver shortages and enforcement of the electronic logging device mandate is motivating carriers to be increasingly selective in the loads they are willing to carry, resulting in a tightened capacity environment. The result is a very fluid and dynamic market. To illustrate this point, costs in our North America truckload business increased 21.5% this quarter, the largest single quarterly increase in our 21-year history as publicly traded company.

I think what you’re seeing in the current market is that we believe that the material or significant price increases are going to stay with us for the remainder of the year.

KB Home (KBH): 7% increase in our overall average selling price

Old Dominion Freight Line (ODFL): It’s obviously been a very favorable pricing environment and we’ve just continued to execute on our long-term pricing philosophy and trying to get the necessary increase to achieve or offset our cost inflation

Carter’s (CRI): …our teams are in Asia now negotiating spring 2019. We’ll have more visibility to those costs in July. We are assuming over the next five years that we’ll start to see some modest inflation. Our experience in recent years has been consistently lower product costs every year. But for modeling purposes, we’re assuming modest inflation in product cost and we expect to offset that inflation with better price realization.

AO Smith (AOS): Pricing actions in mid-2017, primarily due to higher steel and installation costs as well as higher demand for the company’s gas tankless water heaters and water treatment products, contributed to higher sales…

As a result of significantly higher steel prices and inflation in freight and other costs, we announced a price increase up to 12% on U.S. water heater products effective in early June.

The biggest issue both on the residential and commercial is getting labor.

Packaging Corp of America (PKG): We also anticipate continued price inflation in chemical and freight costs, incremental wage pressure with a tighter labor market or slightly lower recycle fiber costs and improving energy costs that will move into the seasonally milder weather.

A lot of freight contracts are coming due – most of my understanding kind of come due in that April-May timeframe. Do you have a sense as to what you’re seeing freight being up on a year-over-year basis? Is it in that 10% to 15% range?

That’s a good number, to your point, and it’s varying by region, by lane.  But nevertheless, we are facing those inflationary cost pressures. I think that’s a good number.

Well, I think, again, it’s a matter of there’s more competition for general labor. And so part of that is it’s a competition based on willingness to pay several wages, and then the environment in terms of are you in a metropolitan region? Are you in a rural region? And so I think we have a good story to tell. But nevertheless, we are dealing in a highly competitive labor market currently which is not all bad.

But that said, there’s no question that labor is a key element that we’re looking at since knowing full well that the costs are going up and that the quantity is going to be somewhat limited, so at least for the short-term.

UniFirst (UNF): In addition, employee wages continued to be impacted by the low unemployment environment. As we continue to invest in our people and infrastructure, we anticipate higher payroll costs as a percentage of revenues. Rising energy prices are also forecast to provide a headwind in the second half of the fiscal year.

Pool Corp (POOL): We — we’ve known for a while there has been a, a very tight market on the freight side, particularly when we’re talking about third party freight carriers and the cost for those services. So that’s kind of rolled into our expectation from an, from an expense standpoint.

My pivot here is with respect to our costs of products and there has been some raw material cost pressures on our suppliers specifically, I had mentioned I think last quarter about some of the components that are used for the manufacturing of the basic sanitizer for pools.

And most recently I saw, recently I saw that one manufacturer announced a 5% price increase effective in June. And I expect that others will follow as their costs pressures are driving them to do that.

I also expect later in the year to be additional price increases products that are affected by one raw material or another.

H.B. Fuller (FUL): We have three areas of focus as we enter the second quarter: first will be to realize over $50 million in annualized pricing to offset last year’s raw material inflation.

And I think, we see further inflation. So there is very much a potential for further price increases. But this is a nice catch-up quarter, if you will, on the margin.

I think logistics cost, especially in the U.S. are up significantly I think every business is seeing that right now. So I was probably little more than anticipated when we started the year…

KB Home (KBH): One, is that 5% cost inflation still what you expect to flow through?

Stephen, we are expecting similar cost. As this year goes forward, there’s pressure on a few of the commodities and we’re all dealing with some of the labor pressures that have been in the news.

Watsco (WSO): Yes, we have been seeing price increase announcements coming from most of the major OEMs. They’re – they range – it’s pretty much up to 6%, 7%, 8%, but obviously, they’re not going to realize that full amount.

I think this is going to be a trial balloon. I’ve been the industry many, many years and it’s unusual for us to have a midseason price increase. I can’t remember the last one, so I have no basis to say whether it will hold or not. I hope it does.

PotlatchDeltic (PCH): In general, I’d say costs are going up in trucking about 10% per year, but like I said at the start we’re really passing those costs along to our customers.

Pulte Group (PHM): Our revenue growth for the period reflects the combination of a 10% or $38,000 increase in average sales price of $413,000 combined with a 9% increase in closings to 4,626 homes.

Scotts Miracle Grow (SMG): The change in our outlook reflects the impact of rising commodity and transportation costs.

Murphy USA (MUSA): Higher gas prices, I mean, if you buy with a $20 bill, you’re going to have fewer gallons per trip. So you have more trips associated with that and we’re absolutely seeing that as well. And so there are pluses and minuses to a higher price environment.

Rent-A-Center (RCII): Same-store sales in the Core segment were positive 0.3% driven by better collections from lower promotional activity and a higher portfolio balance due to an increase in the average ticket.

Bemis Corp (BMS): That’s a normal part of our business. Processes, as contracts come up for renewal, customers are expecting lower input and that’s part of our strategy, is we are constantly working on lightweighting, downgauging and other initiatives, recognizing that that’s an expectation of their customers.

FARO Technologies (FARO): This increase was mainly due to a strong increase in our product gross margin reflecting higher average selling prices in our 3D Factory segment…

Regis (RGS): These benefits were partly offset by minimum wage inflation, healthcare cost increases that were substantially in our stylist community…

one of the things I’m most concerned about as a – not specifically it reaches across the service industries is the ability to attract employees in a virtually a zero unemployment environment. And our challenge is to find young and men and women or more experienced stylists

TPX: We also absorbed $12 million of commodity cost inflation during the quarter as our price increase did not take effect until mid-March.

And as we think about the rest of the year, if I were to digress for a moment, is that the industry typically has been very successful at passing along commodity cost increases in the form of price with a bit of a lag. As we – now turning back – as we talked about commodities for the full-year going into the year, we quantified it in around $30 million. And as we sit here today, we have seen commodity cost inflation. And we’re thinking about it more in the $45 million range. So, we’ve seen a bit of an increase…

Lowe’s (LOW): We recently announced plans to expand our employee benefits and a one-time bonus of up to $1,000 for our more than 260,000 hourly employees in the U.S.

WDFC: we are making some proactive price adjustments in the coming months to ensure our gross margins will remain within our target ranges over the long term.

Krogers (KR): This will be our first contract under Restock Kroger, and it includes an added investment in wages, raising the starting pay to at least $10 an hour and accelerating rate progression to $11 per hour after one year of service. These are the kinds of things we contemplated when we allocated $500 million to the talent portion of our Restock Kroger plan.

Hanesbrands (HBI): As we look out into 2019, we’ve begun communicating the pricing actions that we’ll take to offset the rest of this inflation, and we would expect to have those in place in early 2019.

Werner Enterprises (WERN): The driver recruiting market is increasingly challenging…

World Fuel Service (INT): Consolidated revenue for the first quarter was $9.2 billion, that’s up 12% compared to the first quarter of 2017. This increase was principally due to a 22% year-over-year increase in oil prices

Brinker (EAT): Restaurant labor increased 50 basis points as we experienced higher insurance claims during the quarter that added to the ongoing market-driven wage rate pressures which continued in the 3% to 4% range.

Church & Dwight (CHD): And with respect to the pricing environment, 8 of our 11 power brands had flat or lower percentage of products sold on promotion in Q1 2018 compared to Q1 2017, and still we grew.

As everybody knows, commodities and transportation costs are rising. That’s tempering the appetite to compete on price. Of course, to take price, typically you need a strong position in a category and a cost story to the retailer.

…the trade optimization plans and we have less couponing planned for the year.

And there’s lots of ways to get price. As I mentioned, there’s trade optimization. There’s also less couponing. There’s also pack sizes and how much product you put in the pack. So there’s lots of ways to do that without messing with the list pricing…

Core-Mark (CORE): Transportation continued to be a challenge and was the largest cost overrun…

Badger Meter (BMI): Now copper…from $2.50 a pound in the first quarter of last year to over $3 now, that’s a pretty big jump, and that did hit us for 100 basis points.

Sonoco Products (SON): Moving over the price, you see that prices were higher year-over-year by $22 million, driven by price increases both to cover higher material costs, as well as our other efforts to push through no- contract increase.

Even in Europe where pricing has been difficult for many years, the paper systems have tightened up allowing for price increases to stay.

In addition, resin prices were up 10% to 15% year-over-year in the quarter and some of the increase going into the second quarter. We have increased prices to contractual pass through mechanisms and by direct price increases. So while we’re somewhat behind the price cost curve we fully expect to catch up later in the year.

But we still have work to do to meet our growth and margin improvement targets for the year. Inflationary cost pressures and freight, labor, energy and material costs, particularly resin are requiring us to drive recovery through price increases in many of our businesses.

Valmont Industries (VMI): Steel cost volatility carried into the first quarter. Our historical experience has shown that over time we recover inflationary costs as all market participants face the same cost increases. We have been proactive in raising prices in all of our business…

Despite an inflationary raw material cost environment, we were able to mitigate much of this pressure through a combination of affected supply chain and factory management, as well as pricing actions.

Lincoln Electric (LECO): We will continue to aggressively manage the business against inflationary headwinds.

And I think that the challenge is that the inflationary pressures we’re seeing are really global. So we’ve got a price increases going in across the portfolio,

We’re in a very rapidly increasing inflationary environment.

Tennant Company (TNC): We remain confident in our ability to get adequate pricing pricing. We do — we feel we’re being successful in the market.

Crane (CR): From a price perspective, things are tracking according to plan. We had pricing put in our plans for this year from a guidance and plan perspective. And if anything, we’ve only — we’re only doing a little bit better, I would say, as we’re offsetting much of any material cost headwinds that we’re experiencing.

Astec Industries (ASTE): …price increases that you asked about and we have done that on the pricing side. How much of that sticks remains to be seen, we did that mostly late in the first quarter, our competition by and large is doing the same because the steel cost is a real thing.

Welders and fabricators we haven’t had as much trouble as we have with machinists. Probably the toughest labor market haven’t just gone to almost all of our places in the US and Canada last three weeks, I think South Dakota is probably our toughest labor market.

most of our divisions are running some level of overtime right now. Some of our capacity constraints

Alamo Group (ALG): And so, I mean, I think selectively, we’re buying a little inventory ahead of demand, where – especially – it’s not only where we think price increases are coming, but even more so where we think our lead times are getting longer.

Kennametal (KMT): Also, it’s important to note that we have relatively high utilization levels in some of our facilities currently due to strong market conditions. This affords us the ability to be more selective taking on certain sales, allowing us to liberate capacity to improve fill rates on our high-volume highest-profit products.

The first topic is pricing ability and general raw material cost increases. I think most of you on the call know that the three main raw material costs for Kennametal are tungsten, cobalt and steel, in that order, with tungsten by far being the most important. Raw material cost increases continued in the third quarter. That said, like the first two quarters in the fiscal year, we have been able to cover the raw material cost increases year-to-date and we expect that trend to continue through the fiscal year.

Franklin Electric (FELE): The decline in gross profit margin percentage is primarily due to product and geographic sales mix shifts as we believe the global realized price has offset material cost inflation in the quarter.

Standex (SXI): …we experienced high labor costs from overtime and travel for high value service workers to meet growing customer demand.

CIRCOR (CIR): …we raised prices in our pump businesses globally affecting about one half of the revenue.

Papa John’s (PZZA): So, we’ve had some pressure over the last couple of years on closures, most specifically the West Coast and the Northeast where we’ve had some wage pressures that’s driving some of the unit economic challenges

Dick’s Sporting Goods (DKS): But as far as getting deeper discounts or deeper into a new price battle, we don’t see that right now.

Stein Mart (SMRT): We are encouraged by the sales trend we saw in February and early March driven by very strong regular-priced selling

Aaron’s (AAN): We have pursued this trade-up strategy which has led to higher ticket items

We have our own fulfillment centers and we use outside shippers, so shortage in drivers and increases in fuel costs absolutely affect us. And we’ve seen a little bit of that in the first quarter and we continue to monitor it as we go into the year…

Sykes Enterprises (SYKE): We continue to execute on various actions to address labor tightness and wage inflation crosscurrents in the U.S. These entail employing a combination of tactics ranging from negotiating price increases where feasible, to shifting some existing and new client demand to either better position facilities or to at-home agent model or to other international geographies.

Transcript source: Seeking Alpha

Fabricating Inflation Data

Lincoln Electric Holdings (LECO) is a market leading manufacturer and supplier of welding equipment and systems. It’s one of the many high-quality cyclical businesses on my possible buy list. Although Lincoln’s valuation is too rich for me currently (2.3x EV/sales with cyclical EBIT margins of 5% to 15%), I’m very interested in owning its stock after the current market and economic cycle ends. While Lincoln’s business is performing well, I prefer buying cyclicals during recessions, not extended economic expansions.

Despite not owning LECO’s stock, I continue to monitor their business closely. Historically, I’ve found Lincoln’s conference calls to be very informative – effectively communicating industry and economic trends. Q1’s call was no different.

In my opinion, Lincoln’s Q1 2018 conference call provided valuable insight as it relates to the cost and pricing challenges many companies are currently facing. While there has been a lag (inflation is often a process, not an event), I’m noticing more businesses, such as LECO, are responding to higher costs by raising prices.

Below are some of the call’s highlights related to inflation [my emphasis].

Organic sales increased 9.4% from 5.2% volume growth and 4.2% higher price.

Our performance reflected solid progress in mitigating sharp increases in raw material cost to operational initiatives and pricing actions. We are confident that our global pricing actions and productivity initiatives will allow us to offset inflationary pressures. While there is lag to achieve the full benefit of our initiatives, we are confident that we have the right strategy.

We will continue to aggressively manage the business against inflationary headwinds.

Excluding the acquisition and special items, SG&A increased 11.5% to $133.4 million. The increase was primarily due to unfavorable foreign currency translation effects, higher incentive compensation costs and salary and wage costs. 

And I think that the challenge is that the inflationary pressures we’re seeing are really global. So we’ve got a price increases going in across the portfolio, and there’s no question that pieces of that are probably impacted by some pull forward. But we’ve been in an inflationary environment for these products for a considerable period of time.

We’re putting more increases into the market into the second quarter, but I would also say that the expectation of those normalized incrementals will come when the inflationary environment starts to stabilize.

So I would say the bulk of the price increases did stick the effectivity across our global businesses were very high.

But I think we’re going to continue to see these into very near future at least these mid-single digit types of pricing activities in the welding space.

Well, again I would point out that it is a global challenge associated with inflation. When you see the pricing actions that we took to the international business, I think that there was an enormous amount of price there, as well as our Americas business.

Q: …the biggest concern I hear from investors is around price cost…can you just remind us why you’re confident in the ability of LECO…to recover whatever inflation is out there?

A: Having seen our business perform…over a very long period of time…ability to seek recovery of increases and input costs historically has been a good result for the company. So I’m confident because of that history. I see it playing out again. We’re in a very rapidly increasing inflationary environment.

While I don’t have a PhD in economics, I’m fairly certain “a very rapidly increasing inflationary environment” and a 1.50%-1.75% fed funds rate rarely, if ever, have been seen together.

Despite the sharp rise in short-term rates over the past year, the fed funds rate continues to appear extraordinary low to me. Although I’m only halfway through earnings season, it’s becoming increasingly clear that corporate costs and pricing continue to trend higher. In fact, inflation is quickly becoming one of the most popular topics discussed on Q1 2018 conference calls.

Corporate cost pressures have been growing since 2017. It’s been no secret. Companies such as LECO have been openly discussing these trends. The big mystery, for me anyway, is when will rising corporate costs spill over into the government wage and inflation data? In effect, while businesses are experiencing inflation, many investors and policy makers dependent on government data have yet to be notified.

With labor availability becoming an increasing issue for many businesses, each job report feels like a potential “inflation recognition” land mine. The markets received a mini-scare after January’s report. Will this week’s job report confirm the bottom-up economic data and government data are converging? I don’t know, but I believe the company-specific evidence as it relates to wages and inflation continues to build.

As an absolute return investor, I’m thankfully not required to remain invested and can watch and wait from a safe distance. At this time, I have no interest in owning long-term bonds or equities priced as risk-free perpetual bonds. There are many risks I’m willing to take, but at this stage of the cycle and at today’s prices, duration risk is not one of them.

Transcript source: Seeking Alpha

Peak Promotions

For most of the current profit cycle, the retail industry has been burdened by overcapacity and unsettling ecommerce trends. As a result, the environment for many consumer companies has been challenging and highly promotional.

While deep discounting remains popular, not everyone has conformed to the promotional norms. In fact, based on recent earnings results and commentary, the reliance on promotions appears to be receding, while the emphasis on “full-price” sales is gaining momentum.

Two Bloomberg articles recently touched on this subject. The first article, “Clothing Retailers Are Finally Catching Some Breaks” highlights the improving same-store sales of apparel companies. While several reasons were noted, the following comment from Bloomberg’s apparel analyst caught my attention.

“The improvement likely suggests clothing retailers lately have done a better job selling full-price goods, relying less on promotions and discounts.” [my emphasis]

While the full-price model isn’t new, I believe more businesses are considering and in some cases transitioning. Ralph Lauren (RL) is the first company that comes to mind when I think of companies choosing profits over promotions. Stein Mart (SMRT), my favorite apparel retailer (for shopping, not investing), is another good example.

In March, Stein Mart reported a significant improvement in earnings, causing its stock to spike 68%! Although Stein Mart’s same-store sales remained negative, operating income rose sharply due to a 380 basis point increase in gross margins. The quarterly improvement was driven by lower inventories, fewer promotions, and “significantly increased regular price selling”.

Stein Mart’s transition from relying on promotions to improving profitability wasn’t easy. From Stein Mart’s conference call:

“As you can see from our 2017 results however, transitioning to lower and healthier inventories can have a short-term impact on sales and margins. Through the third quarter of 2017 margins were hurt by additional markdowns to clear excess inventory.”

However, its transition is finally paying dividends…

“This better mix of more regular price sales and less clearance in the quarter as well as higher mark ups resulted in an overall better margin.”

…with higher margin trends continuing.

“Our sales are now much more profitable with the lower clearance level. Our current regular price selling results are strong.”

And finally, management provided an optimistic assessment of current sales trends.

“For the month of February with spring selling underway, our sale trends have improved dramatically compared to last year driven by higher regular price selling offset by lower clearance selling.”

While competition remains fierce, pricing pressure may also be stabilizing in other areas of retail. During Dick’s Sporting Goods (DKS) most recent conference call, management stated they hope to receive “full margin” on newly released innovative products. Furthermore, as it relates to promotions and the competitive environment, management implied stability.

“But as far as getting deeper discounts or deeper into a new price battle, we don’t see that right now. But that’s as of today that can always change tomorrow.”

[Side note: I’ve recently received an unusually high number of promotional emails from DKS. The last time I noticed this, they had a poor quarter!]

Another consumer company, Darden Restaurants (DRI), also discussed the current promotional environment and the possibility of changing trends. Below are management’s comments related to the industry’s rising check average.

“But, the real change that we’re seeing…is that the check average appears to be growing and has picked up some steam. And as we look at that, we’re trying to analyze whether that is the industry taking more pricing, is it a pullback on some discounting, is it change in promotional strategy?

Highly promotional trends may also be subsiding in other sectors of the economy, such as durable goods. A recent Bloomberg article, “Americans Urge to Splurge Making Inflation Hawks Edgy” analyzed the University of Michigan’s latest survey of consumer sentiment. The survey indicated shoppers of durable goods are anticipating lower promotions and higher prices.

“More American consumers than at any time in 27 years are convinced that it’s better to make big purchases now because retailer discounts and deals won’t be around much longer.

The director of the survey, Richard Curtin, made the following comments.

“When asked about buying conditions, the appeal of low prices has largely disappeared. For durables, it has been replaced by favoring buying in advance of anticipated price increases.

Excluding companies that are not required to generate an adequate return on capital (wink, wink, you know who you are 🙂 ), the path to prosperity is rarely filled with deep discounting and price wars. As such, it’s rational to assume the number of companies exiting the promotional mud pit — dead or alive — will continue to increase.

In my opinion, increasing wages, along with elevated store closures and bankruptcies, should benefit surviving businesses attempting to kick their deep discounting habits. Assuming more companies follow the less promotional path, it will be interesting to learn how sales, margins, and consumer prices respond. As Q1 earnings roll in, peak promotions is one of many trends I plan to monitor and analyze.

_____________________________________________

With earnings season picking up steam, I may be unable to post for the next 2-3 weeks. Good luck to those who remain in equities. And for those patiently investing in cash, t-bills, and short-term Treasuries, yields are becoming more and more interesting! Yesterday the 12-month Treasury hit 2.15%, with the 2-year USTN yield reaching 2.43%. It remains a great time to check those cash balances and make sure you’re not getting short-changed by a bank or money market fund.

Sometimes I feel like the only person excited about higher short-term rates. I attended a social event last weekend and no one, I mean no one, was talking about the sharp run-up in short-term yields. They should be. Just look at the 2-year yield chart — it’s beginning to look more impressive than most FANG stocks! Now at 2.43%, the 2-year was only yielding 0.75% a couple years ago. It’s been a huge move (link to 2yr chart).

Hopefully short-term rates continue to march higher, rewarding patient investors with either higher income or an abrupt end to the current market cycle (lower equity prices).

I hope everyone has a wonderful earnings season! I’ll be back in a few weeks.

transcript source: Seeking Alpha

Q&A with Michael Lebowitz

Below is an article by Michael Lebowitz of Real Investment Advice and 720 Global. In addition to asking several questions related to absolute return investing, Michael discusses the common sense approach of buying low and selling high. I always find it fascinating how such a simple and logical investment approach can sound so contrarian, especially during market extremes.

Although buying low and selling high may appear easy, in practice it is very difficult. When prices are low and declining, fear can overwhelm investors, causing them to freeze. Conversely, when prices are high and rising, greed and adrenaline can work like a drug, causing investors to become hooked and wanting more. In effect, it is fear and greed that make buying low and selling high so difficult and surprisingly unique.

While buying low (taking risk) and selling high (avoiding risk) is an important part of my process, to be clear, I am not a market timer. My buy and sell decisions are determined by the value, or lack thereof, within my opportunity set. In other words, portfolio cash levels are valuation-based and built from the bottom-up (individual security research and selection).

Currently, valuations within my 300-name possible buy list are very expensive and in my opinion, do not provide adequate future returns relative to risk assumed. Therefore, I’ve decided to hold cash instead of what I believe are overvalued small cap stocks.

With that, I’d like to thank Michael for his interest in absolute return investing! I hope everyone enjoys our discussion.

Value Defined: An Interview with Value Investor Eric Cinnamond