Conversation With Preston and Stig

I recently had a conversation with Preston Pysh and Stig Brodersen of The Investors Podcast (link below). After doing a podcast with Jesse Felder a few months ago, I was somewhat hesitant to do another one as I wasn’t sure I’d have much new to say. However, Preston and Stig did a great job digging into my investment process and covering new ground.

One area I found particularly interesting was our discussion on valuing asset heavy companies. In fact, I planned to write a post on this subject last week, but Hurricane Irma had other plans…including a mandatory evacuation and tearing down our screened porch! Despite the minor damage and inconvenience, all is well and we’re grateful the storm weakened before hitting Florida. I’m hoping to get back into my routine this week and will be posting again soon.

Podcast:  Conversation With Preston and Stig

It’s Not You, It’s Me

As a portfolio manager, I’ve been hired and fired by clients many times. Similar to investors trading stocks and bonds, advisers and consultants trade portfolio managers – some are hired, some are fired, and many are analyzed. Advisers and consultants have processes and disciplines as well, with the manager selection process customized to meet their investment objective. During this process, managers are screened, interviewed, and ultimately selected. It’s not very different from an analyst or portfolio manager performing due diligence on a company. It’s a continuous process, with constant review and varying degrees of manager turnover.

Most portfolio managers, including myself, would prefer clients stick around for a complete market cycle. Of course not all capital is that sticky or patient. In reality, from what I’ve gathered over my career, the most popular time allotment granted to managers is approximately three years.

Depending on the market cycle and when a portfolio manager is hired, a three year evaluation period may be insufficient and possibly counterproductive. For example, imagine being an asset allocator in 1999 and you’re considering hiring or firing portfolio managers based on their 3-year performance. The data would suggest firing managers avoiding tech and hiring managers that were about to incur significant losses. Or how about 2005-2007? Judging 3-year performance over this period would encourage rewarding managers invested in financials and punishing disciplined managers refusing to overpay.

My 3-year relative return numbers have ranged from outstanding to horrific. Given the extreme equity valuations we’ve experienced over the past twenty years, my absolute return process and discipline has required very unique and contrarian positioning. As a result, significant swings in relative performance were common and expected. High tracking error and my willingness to look different often landed me in first or last place in the relative return derby. In fact, on more than one occasion I’ve been called Ricky Bobby, referring to the Ricky Bobby in Talladega Nights who eloquently said, “If you ain’t first, you’re last!”

When in last place, it wasn’t unusual for certain clients and assets to leave. While disappointing, I understood. Manager changes and shifts in asset allocations are a natural part of the investment management process.

Although manager turnover should be expected, I found the timing of certain inflows and outflows interesting. Assets would often flow into my strategy after periods of strong performance and leave after periods of weak performance. It was classic rearview mirror investing.  In hindsight, I was often fired when I should have been hired, and hired when I should have been fired.

Again, it’s similar to buying and selling individual securities. Have you ever been so frustrated with a stock that you sell it and it goes on to double or triple? Or how about buying a stock that never declines, only to watch it crash a few months later. Advisers and consultants battle the same tendencies and emotions as portfolio managers. Furthermore, they are just as susceptible to the dangers of extrapolation and career risk. Whether you’re an adviser, consultant, or portfolio manager, buying low and selling high sounds easy, but in most cases it is not.

In my attempt to buy low and sell high, I’ve often been required to invest in out of favor stocks and sectors, such as energy in 2009 and precious metal miners in 2014-2015. My absolute return portfolio’s energy weight peaked near 20% in early 2009, while the miner position ranged from 10-15% in 2014-2015. When taking such large positions in underperforming assets, effective client communication is essential.

Buying and holding the precious metal miners was particularly challenging and required frequent and thorough client communication. During this period I had many conference calls and meetings explaining the portfolio’s positioning and my decision to own the miners.

I remember one meeting in particular in 2015 with a large and sophisticated client. The lead consultant was very smart and was known to ask tough, but fair questions. Considering the miners were the largest weight in the portfolio and were performing poorly, I was certain we’d spend considerable time discussing the position. And we did.

I started the discussion by reviewing my valuation methodology and reasoning behind the precious metals position. I explained my belief that miners were a classic contrarian investment and were selling at significant discounts to their net asset values. I argued miners were an area value investors should be swarming over, not avoiding – especially in a market with limited volatility and opportunity. I called the miners a gift and was surprised more value investors weren’t interested. I suspected the position was simply too embarrassing to hold for most professional investors, carrying unbearable levels of perception and career risk. I explained this was why miners were so inexpensive relative to their difficult to replace long-lived assets.

I should have stopped there. Instead of wrapping up my argument based on facts and sentiment, I did something I rarely do. I pulled out an old Warren Buffett quote and said, “As Warren Buffett likes to say, be greedy when others are fearful and fearful when others are greedy.” Nice closing, I thought. How can anyone argue with that? But then came a quick and sharp response, “Well then, does Warren Buffett own the miners?” Oops. He did not and I knew he never would. I responded with the unfortunate truth, “Hell no, Warren Buffett would never own these things!”

I was lucky. Instead of getting fired on the spot, everyone laughed. Even better, the client stayed with us and eventually benefited from the strong rebound in the miners. Thankfully the consultant did not sell low and buy high as emotions and career risk would pressure most to do.

Interestingly, after performance improved, we eventually lost the account due to a firm-wide asset allocation decision. In the asset management business, when you’re fired due to an “asset allocation decision”, it’s the equivalent of “It’s not you, it’s me” in dating. In reality we all know it probably was you (or in this case me)! 🙂

In conclusion, asset managers are hired and fired regularly – turnover is a natural part of the investment management process. Ideally, portfolio managers are allowed a full cycle to achieve their investment objectives; however, as we know, evaluation periods are typically shorter than desired. Like stocks and bonds, managers can be traded too frequently, or at inopportune times. Short evaluation periods, extrapolation risk, and career risk, can all amplify the urge to flock into the best performing funds and managers. Asset allocators should be alert to groupthink, concentrated flows, and the risk of buying managers high and selling them low. Currently in the ninth year of one of the most expensive market cycles in history, I can’t help but wonder where today’s risk is most concentrated. Is it with portfolio managers who are being fired or hired?

Role-Play Screening

I’m often asked how I screen for small cap stocks. Most of my formal screens are broad-based and only include a market cap and profitability filter. Specifically, I require a $100 million to $5 billion market cap and a 1% return on equity (ROE). Although a 1% ROE hurdle may seem inadequate, considering the high number of unprofitable small cap companies, even low profitability requirements can be effective in eliminating many lower quality candidates. In fact, depending on where we are in the profit cycle, I’ve found a third to a half of small cap stocks are kicked out of my screens once profitability is required. Another reason I keep profitability hurdle rates low, is I want to avoid kicking out high-quality cyclical companies generating trough operating results (also why I rarely screen on P/E). In general, when screening, I want to be as inclusive as possible and avoid becoming a Grey Poupon Investor.

After screening for market cap and profitability, I attempt to weed out companies with inadequate financial strength and liquidity. Specifically, I discard companies with debt levels above 3-5x discretionary cash flow (depending on the cyclicality of the business). I want to be extremely careful to never find myself at the mercy of a fickle banker or an emotional bond market. After finishing my balance sheet screening, I toss out companies I’m familiar with that I refuse to own for one reason or another (management, strategy, industry, capital allocation, etc.).

Once my screening process is complete, I’m usually left with approximately 500 small cap stocks, with many already on my possible buy list. On average, I discover one or two new ideas a month. These ideas are initially placed on my possible buy list and rarely go into the portfolio immediately. I like to follow new buy list names for at least six months before purchasing. I want get to know the businesses well before allocating capital. Furthermore, I want to avoid making valuation errors resulting from inaccurate first impressions. Are you familiar with that exciting feeling you receive shortly after uncovering a great investment idea? That’s an emotion — be careful. Your excitement could cause you to jump to conclusions you want to be true. I like to fight this urge with time, walks, and further thought.

In addition to my formal screening process that sorts through a large portion of the small cap market, I also like to run focused screens on out of favor sectors. Excessive pessimism within an industry can create tremendous opportunity. Examples include energy in 2009 and precious metal miners in 2014-2015. During these severe sector bear markets, I ran industry screens searching for companies that had an above average probability of surviving their industry’s recession. Screening for and assessing financial risk was critical. While it’s nice buying an attractively priced stock, if the balance sheet isn’t strong enough to survive the cycle, large discounts to value and margins of safety can quickly become irrelevant.

How do I determine what sectors are most out of favor? One of my favorite methods is role-playing. Specifically, I like to put myself in the shoes of a highly-paid relative return manager running billions of dollars. I pretend to own a luxurious house, fancy cars, vacation homes, and a big boat (maybe with a helicopter, maybe). I’m living the dream. I then envision year-end is approaching and I’m heading down the stretch of the performance derby. It’s bonus determination time! Finally, I imagine I’m about to have a dozen client meetings with some of the country’s largest investment consultants. My relative performance has been average and I’m aware the AUM in my fund is at risk. I then ask myself, what stocks and sectors do I want to avoid owning and discussing during my upcoming meetings? And what area of the market would be too big of a drag on near-term performance and too risky to own from an AUM perspective? Answer these questions and you’ll often find elevated perception risk and the most undervalued sectors of the market.

Where is perception risk highest today? While not as disliked as energy in 2009 and the miners in 2014-2015, I believe retailers and energy are two areas relative return investors appear to be avoiding. How many relative return investors want to own under-performing retailers and energy stocks heading into year-end? I’m not sure, but in my game of pretend, I sure don’t!

Now back to reality. As an absolute return investor, I love bear markets, even if they’re isolated to specific stocks or sectors. As year-end relative performance anxiety mounts, I’m hopeful the selling pressure in retail and energy continues and possibly intensifies. I’m optimistic and ready.

Bottom-Up Economics

What comes after earnings season? More earnings! Many consumer companies, especially retailers, have fiscal years ending in January. As such, they typically report earnings a month after companies using a calendar year. Several consumer companies on my buy list, along with high-profile market leaders, reported earnings last week. For the most part, results were similar to last quarter and in-line with the Q2 management commentary I recently summarized.

Before we review consumer results, did anyone notice Amazon’s bond offering last week? As brick and mortar retailers struggle to maintain market share and traffic, Amazon issued $16 billion in debt with ease. According to Bloomberg, Amazon sold “the longest portion of the offering, a 40-year security” 145 bps above Treasuries. Who is more generous, buyers of Amazon’s debt or its equity? And what is more frightening to Amazon’s competitors, the fact Amazon can borrow so much at such low rates, or that the company hasn’t been required to generate an adequate ROIC for the majority of its existence? It’s no wonder Amazon is taking market share and threatening profit recessions in a growing number of industries.

The current market and credit cycle has created an interesting tug of war between inflation and deflation. On the one hand, extremely aggressive monetary policy has created record asset inflation and easy credit, artificially supporting demand. On the other hand, overabundant capital has contributed to overcapacity and margin pressure in a variety of industries (see energy and retail). While these conflicting forces are interesting to ponder, I’ll stop here before I make an unqualified statement on what it all means for investors. Plus, does the world really need another fundamental value investor making top-down macro observations and predictions? Probably not. Instead, let’s get back to viewing the economy through the eyes of businesses – or as I like to call it, bottom-up economics.

Before we begin, I wanted to point out that while my focus is on small cap stocks, I also follow several mid and large cap businesses. Although larger companies are not on my possible buy list, I often review their results to gain information on certain industries and the economy. With that housekeeping item out of the way, let’s move on to what’s happening in the real world.

Wal-Mart (WMT) reported a 1.8% increase in same-store sales (1.4% last quarter) and a 1.3% increase in traffic (1.5% last quarter) at its U.S. stores. Ticket was up slightly while inventory per store declined 3.8%. Consolidated gross margins declined 11 bps due to “strategic price investments” and growth in e-commerce. Apparently the market wasn’t satisfied, as Wal-Mart’s stock declined on the report. Investors may have been disappointed with Q3 guidance, which did not indicate an acceleration in growth.

Target’s (TGT) comparable sales were also in the low single-digits, increasing 1.3% (digital channel sales contributed 1.1%). For the year, management expects comparable sales of plus or minus 1%. Gross margins declined 40 bps due to higher e-commerce fulfillment costs and “efforts to improve pricing and promotions”. Higher compensation costs contributed to an increase in SG&A. Management called the competitive environment “choppy” but was pleased with its 2% increase in traffic. Lastly, similar to Wal-Mart, inventory declined (more than 4%) versus a year ago.

Although Wal-Mart and Target were only able to generate low single-digit comps, they were positive and showed signs of stability. Other more discretionary retailers were less fortunate. For example, Foot Locker (FL) reported second quarter comparable-store sales declined -6.0%. The company’s gross margin declined noticeably to 29.6% versus 33% a year ago. Management blamed the shortfall on top styles falling short of expectations along with the “limited availability of innovative new products.” Management isn’t expecting a change in the near-future and believes comparable sales will decline 3-4% for the remainder of the year. Commenting on the industry management said, “The disruption taking place today in our industry, and in retail in general, is the most significant I’ve seen in my quarter-century in the athletic business.” Foot Locker’s stock declined 28% on the results and guidance.

Foot Locker is a good example of the risks associated with extrapolation. It’s a cyclical consumer business that was being priced as a consistent grower. As I wrote in April (Living the Minivan Dream), “I’m currently not assuming Foot Locker’s 13% operating margins are perpetual. In fact, when a mature retailer in a competitive market generates such high margins, the first thing that comes to my mind is their customers are paying too much. Instead of asking how management will expand margins further, as an investor, I’d question how a mall-based retailer can sustain mid-teens margins long-term.” Since April, Foot Locker’s stock has declined from $72 to $33.

Sticking with the athletic theme, Dick’s Sporting Goods (DKS) also disappointed investors last week. Specifically, earnings and same-store sales came in below expectations, with comps only increasing 0.1% (up 2.4% last quarter). Management stated the retail industry is in flux and highly competitive. To protect market share, Dick’s is turning to promotions and lower prices. As a result, the company lowered full year EPS guidance to $2.80-$3 from $3.65-$3.75. Same-store comp expectations are now flat to negative low single-digits versus previous guidance of 1-3% positive comps.

Commenting on the industry management noted, “There’s a lot of people right now, I think, in retail and in this industry in panic mode. There’s — it’s been a difficult environment. I think people — I’m not going to speculate what they’re thinking, but they seem to be in panic mode with how they’re pricing product. And we think it’s going to continue to be promotional and at times, irrational going forward. And I think that’s going to be across a number of different sectors.” Considering the number of $20 off coupons I’ve been receiving from them in the mail, I should have seen this one coming!

Do results from Foot Locker and Dick’s Sporting Goods imply a fashion shift from athletic to more formal attire? Is full employment finally causing consumers to dress more professionally? Are sweat pants and sneakers being traded in for suits and dress shoes? For answers, let’s turn to Tailored Brands (TLRD), a market leading retailer of men’s suits. Although Tailored Brands doesn’t report results until September, with last quarter comps declining -2.4%, trends have not been encouraging.

My favorite apparel retailer for dress shirts and pants (also where I buy my $199 suits!), Stein Mart (SMRT), also reported weak results. Sales declined -2.7% last quarter, while same store comps decreased -5%. If consumers are spending less on athletic and more on other areas of apparel, Tailored Brands and Stein Mart do not appear to be benefiting.

Instead of buying $100 running shoes and $199 suits, maybe consumers are remodeling their homes. Home Depot (HD) reported another solid quarter with same-store comps increasing 6.3% (5.5% last quarter). Transactions increased 2.6% and average ticket was up 3.6%. Management noted commodity inflation in lumber, building materials, and copper (aided comps 68 bps). Big-ticket items (over $900) continued to do well, increasing 12.4% (22% of sales). Interestingly, transactions for tickets under $50 (16% of sales) were only up 1.5%.

Due to the “continued growth in the repair and remodel market as the U.S. has experienced solid wage growth, faster home price appreciation and the reemergence of first-time home buyers,” management raised its guidance and expects same-store comps of 5.5% for the year. While the Fed’s asset inflation policy may not be working for most retailers, it is clearly benefiting home prices and Home Depot – they are in the right place at the right time. However, as Foot Locker shareholders will attest, Home Depot investors may want to be careful extrapolating those healthy comps and margins too far into the future!

Briggs & Stratton (BGG) announced weaker than expected results with sales declining -5.6%. Although sales to commercial customers (includes lawn care for the 1%’ers) were strong, residential sales (consumers who cut their own lawns) were weak. Management blamed unexpected shifts in partner inventory and “pockets of suboptimal growing conditions”. Management continues “to see a cautious approach to reordering as channel partners have focused on controlling inventory to abnormally low levels.”

Advanced Auto Parts (AAP) reported flat same-store comps for the quarter and guided to negative -1% to -3% comps for the year. The company attributed recent softness in industry sales to economic uncertainty for low-income consumers and higher year-over-year gas prices, leading to a reduction in the growth rate of miles driven. Management also pointed to “a temporary trough in vehicles in the aged and maintenance sweet spot resulting from a substantial decline in new car sales in the 2008-2009 recession.” And finally, management believes a cooler spring and summer may have hurt results (less work on A/Cs).

TJX Companies (TJX) reported a respectable quarter with same-store comps increasing 3%. Positive comps were mainly a result of higher traffic and do not include the benefit of e-commerce revenue. Inventories on a store basis declined 6%. Wage increases reduced EPS by 2%, as anticipated. The company is expecting comps of 1-2% next quarter and in fiscal 2018. Management sounded confident in its off-price strategy and continues to expand its store count.

Restaurants continue to struggle. Zoe’s Kitchen (ZOES) comparable sales declined -3.8%. Zoe’s comps were aided by a 1.2% increase in price, while transactions and mix hurt comps by -5%. Wages increased 2% for hourly employees. Management also announced they expect to moderate store growth next year. Full year comps are expected to be flat to down -3%.

Brinker International (EAT) announced same-store comps declined -1.8%, which was “consistent with what we’ve seen in the industry over the last couple of quarters.” At company-owned Chili’s, comps were down -2.2% with traffic declining -6.6% (price was up 2.9%). Management expects comps for fiscal 2018 to be flat to 1%. Guidance for 2018 also includes wage inflation of 3% to 4% (meanwhile central bankers will fret about deflation at their Jackson Hole meeting this week???).

And finally, DSW Inc. (DSW) reported earnings this morning. I have not listened to their conference call yet, but the quarterly report showed signs of stabilization. As I noted in a post a few months ago (Retail Survivor), there will be survivors in retail and I expect DSW to be one of them. Comps stabilized and were up 0.6%. DSW’s balance sheet continues to look strong and liquid. With its stock up 20% this morning, investors appear pleased with the stabilization in comps (albeit at a low level).

In conclusion, the consumer backdrop is little changed since last quarter and remains sluggish. Apparently Dow 22,000 wasn’t enough to sufficiently stimulate consumer demand. Forget the Fed’s consumer inflation target, what is the “appropriate” level of asset inflation? Is it Dow 25k, 40k, or 100k? In effect, what level do asset prices need to reach for consumer comps to grow 3% to 4% instead of -1% to 1%?

On a more positive note, barring a recession, quarterly comparisons for many consumer companies should become easier later this year. The consumer slowdown I noticed last fall will soon reach its anniversary. However, as can be gathered from the results and outlooks of several retailers and restaurants, stabilization does not necessarily equal acceleration. Nevertheless, similar to DSW and Target, stocks of depressed retailers that transition from negative comps to slightly positive comps could see a lift.

Sorry for the long post today. I’m officially finished with earnings season and plan to refocus my efforts on more in-depth research. With the small cap market leaking and pockets of weakness in certain sectors — energy and retail in particular — there are actually some potential buy ideas to work on these days. It’s not much, but it’s something!

What’s Happenin’

Over the past three weeks I’ve reviewed approximately two hundred earnings reports and conference calls. While very time consuming and exhausting, my quarterly earnings routine is an essential part of my investment process. With an up-to-date summary of where we are in the profit cycle, I’m better able to normalize earnings and more accurately value the small cap companies I’m considering for purchase.

Although I’m bearish on small cap prices and valuations, I do not believe the U.S. economy or corporate profits are currently in recession. While second quarter operating results were inconsistent and varied between industries, on average, sales and profits increased modestly. In my opinion, Q2 2017’s results were similar to Q1 2017 and were commensurate with a slowly growing economy – a trend that has been in place since Q3 2014 (interestingly the end of QE3 was announced in October 2014).

Based on the operating results of my opportunity set, I continue to believe the U.S. economy is growing in the low single-digits. Last quarter I stated Q1 GDP growth of 0.7% appeared low (was recently revised to 1.2%). At 2.6%, Q2’s GDP growth looks a little high in real terms. However, on a nominal basis, the mid-3% growth reported in both quarters appears reasonable. To get a more accurate measurement of real GDP, I suggest averaging Q1 and Q2, which puts real GDP growth slightly below 2% and more in-line with my bottom-up observations.

Below is a summary of several business trends I noticed during the quarter.

  1. Consumer companies, on average, continue to report sluggish operating results. Most volumes and comparisons remain low single-digit positive to negative. Strategies to combat weak volumes and traffic vary, with some consumer companies turning to promotions, while others are reducing inventories and increasing price. Regardless of the strategy, it’s an extremely competitive environment with companies fighting tooth and nail to protect market share or margins (tough to protect both). On the bright side, quarterly comparisons are getting easier (it’s been almost a year since I noticed the consumer slowdown: Consumer Alert). Furthermore, inventories are tightening, which should stabilize margins and reduce the risk of further destocking. However, lower inventories and fewer promotions may also lead to higher consumer prices.
  2. Despite reports of tame consumer and producer inflation, many businesses reported cost pressures and pricing action in Q2. I’m not certain if or when these increases make it into the government data, but I listed dozens of examples of cost and price increases in my quarterly management commentary write-up (available upon request). Although inflation isn’t spiking higher, it was definitely noticeable in Q2 and certainly isn’t dead (as the bond and equity markets have priced in).
  3. Industrial businesses, on average, had a good quarter. Companies tied to construction and aerospace/defense reported healthy results. A rebound in energy spending also contributed to improved results. However, the benefit from energy should moderate in Q3 and Q4 2017 as comparisons get more difficult (rig count troughed at this time last year) and the direction of energy investment is less certain.
  4. Investment in domestic energy infrastructure rebounded again in Q2. Barring further declines in energy prices, most energy companies appear comfortable maintaining 2017 spending. However, rig count growth is moderating sequentially, so expect growth to slow in Q3 and Q4. 2018 remains very uncertain as most capital expenditure decisions are on hold – energy companies are in wait and see mode. And finally, offshore remains very weak with no rebound expected.
  5. Auto manufacturing is declining slightly. Most companies aren’t predicting a major decline, but there doesn’t appear to be strong conviction on future trends.
  6. Agriculture remains challenging, but seems to have stabilized at lower levels.
  7. Transportation volume and pricing appears to be improving modestly. Weakening dollar could help rails/exports.
  8. Financials are doing well on average. Loan losses at banks are manageable. Insurance may be a bigger trouble spot at the end of this cycle than banking. I believe there is a growing risk insurance companies are underwriting too aggressively to maintain premium growth. And of course their investment portfolios are tied to the bond and equity markets to different degrees.
  9. Technology results and trends mixed. I need more data.
  10. Currency was not a major factor in Q2.
  11. Outlooks and commentary suggest Q3 2017 should be similar to Q2, or what we’ve seen since mid-2014 – slow aggregate growth, with the dispersion between industries continuing.
  12. Certain companies and sectors, such as consumer staples and technology,  appear to be getting a pass on earnings misses, while others such as consumer discretionary and energy are not. It’s as if investors are normalizing operating results for some businesses, but not all. This is just an observation on sentiment and conformity (possibly exaggerated by ETF and passive investing – what’s working or popular are larger weights in benchmarks which benefit more from investment flows into passive). I do not have supporting data on this – again, just an observation.

As always, if you’d like to read some of the management commentary that helped form my macro opinion, please shoot me an email. It’s a little longer than normal this quarter (over 50 pages) and was too lengthy to post.

In addition to financial and macro related commentary, there is always plenty of other interesting and entertaining content on quarterly conference calls. In fact, I learn something new every earnings season. For example, as it relates to long-term economic growth, I found Church & Dwight’s (CHD) comments related to their TROJAN division very relevant and interesting. In effect, are smartphones contributing to the decline in population growth and household formation?

Church & Dwight’s management explains, “The condom category declined in consumption by 3% in the quarter. TROJAN condom share in measured channels was down 150 basis points. Although some of that is offset by online consumption — condom consumption, all channels has been soft for the last few quarters. Our research suggests that young people are having less sex. Some of the factors are demographics, young people living at home longer, and surprisingly, the distraction of mobile phone usage.”

If young people are having less sex due to the distraction of their smartphones, is it safe to assume they’re doing less of everything? If so, this could help explain why consumer demand for many products and services has been weakening. Instead of shopping, eating out, or attending a sporting event, maybe a growing number of young consumers prefer spending their time “non-GAAPing” their Facebook page (presenting your life without bad things) or watching episodes #54-#58 of Breaking Bad on Netflix!

Counting Boxes

I continue to plow through earnings season and will hopefully finish in the next week or two. At that time I’ll put together a summary of what I’m seeing within my 300-name opportunity set. Although my review isn’t complete, I’m noticing a few interesting trends.

As the Federal Reserve and bond market remain fixated on statistics suggesting disinflation, signs of rising costs (including labor) and pricing power are appearing in Q2 earnings reports. I thought Sonoco Products Company’s (SON) second quarter results and management commentary were particularly interesting.

Founded in 1899, Sonoco is a leading manufacturer of industrial and consumer packaging. It’s a relatively simple business with a long operating history and respectable track record. Selling at 18x 2017E earnings, Sonoco‘s valuation isn’t cheap, but it’s less expensive than most of the high-quality equities on my possible buy list. In my opinion, Sonoco’s relatively subdued valuation is a result of slow earnings growth. For the year Sonoco expects EPS of $2.73 to $2.80 versus $2.72 in 2016.

During the second quarter, Sonoco’s gross margin was under pressure due to declining volumes and rising costs. SG&A was also higher, partially due to wage inflation. In an attempt to offset higher costs, Sonoco is raising prices. In fact, higher prices contributed 4% to sales growth in Q2, while volume and mix subtracted 1.9% (total sales growth was 3%).

Commenting on sales and volumes, management said, “One of our toughest challenges right now is dealing with generally weak demand from many of our Consumer Packaging customers. This isn’t new. Consumer Packaging volumes have been flat to down since the end of 2014 as consumers’ preference for packaged food is clearly being impacted by changing taste for more fresh and natural products.”

Sonoco is in a tough spot with declining volumes and rising costs. The rising cost of OCC (old corrugated cartons – used in recycling) has been particularly noticeable. According to management, OCC pricing in the Southeast averaged $165 per ton versus $87 in the same quarter last year. On their Q2 conference call management commented, “As most of you know, Sonoco is a significant recycler and consumer of OCC. The cost of OCC reached historic levels in March, then declined in April and May but has now pushed back to record levels of $185 a ton in the Southeast.”

What is causing the spike in OCC prices? Management believes e-commerce may be a possible contributor. Specifically, the OCC supply from retailers, or as management calls it, “what’s available behind the stores,” may be in decline. As e-commerce grows, the number of boxes carrying merchandise directly to homes is increasing, which reduces the number of boxes sent to retailers. Considering the collection process of OCC from stores is more efficient than from homes, it’s reasonable to assume less OCC is finding its way into the recycling supply chain.

Management explains, “One of the things that is still confusing me, and I must say this, is e-commerce isn’t new. It’s been here for some time. What’s so unique about this particular year? I think that we really need to get our hands around that. We’re working internally to better understand it. AF&PA [American Forest and Paper Association] is also working to understand how you improve recycling rates through the home — through homes versus behind the stores.”

As the industry determines how to recycle OCC from homes more efficiently, Sonoco isn’t sitting still and is responding with higher prices. Management believes they are early in the process and are “going to go for recovery.” Sonoco isn’t alone. Management states, “These are real increases, every one of our competitors. No one’s not receiving these cost increases. So I remain fairly confident that our competition understands the magnitude of the increase that’s hitting them, and we’ll react accordingly.”

I find all of this very interesting. While the structural shift in retail may be having an impact on OCC prices, what about shifts in store inventory and consumer demand? When I started as a buyside analyst, I remember retail analysts would visit shopping centers and count cars in parking lots as a way to measure consumer traffic and demand. Today, instead of counting cars, maybe it would be more useful to go behind stores and count the stacks of empty boxes waiting to be recycled! Based on OCC pricing, I wouldn’t be surprised if they found fewer boxes than a year ago.

Despite all of the attention deflation and disinflation have been receiving, there are clear examples of rising costs and pricing power in recent earnings reports. As a patient absolute return investor, I view inflation as one of the many potential catalysts for future opportunity. Put simply, what happens to central bank asset purchases and the Fed put once inflation reaches a level similar to Sonoco’s pricing power (4%)? They vanish along with the belief profit and market cycles are a thing of the past.

The Third Time is the Charm

It’s been ten years since the housing and mortgage bubble began to unravel. While the exact date is debatable, I remember July 2007 as a very important month. It was when Bear Stearns announced two of its funds holding subprime mortgages lost most of their value. Shortly after, the marginal buyer or borrower discovered it would become more difficult to obtain a mortgage. It was the beginning of the end for the housing bubble and the 2002-2008 market cycle.

The housing bubble was an important time in my life and career. As home and stock prices soared, I was again forced to invest very differently from my peers and benchmark. As a result, performance lagged throughout most of 2003-2006, while the credibility I gained during the previous cycle began to fade (apparently past bubble cred is nontransferable!). I went from being one of the portfolio managers who got the tech bubble right, to the manager who was getting the housing boom all wrong.

Although my positioning and message wasn’t very popular, I tried to convince as many people as possible that we were in a bubble. The first person I tried to convince was my wife. Our modest house in Florida appreciated 55% in only two years! I wanted to sell before the bubble popped, but wasn’t sure if my wife would agree.

Initially she thought I was nuts. “We just bought the house,” she explained. “You’re right, but these gains aren’t real – it’s all one big bubble,” I argued. While you won’t hear this from Dr. Phil, one of the keys to a successful marriage (and parenting for that matter) is mastering the art of bribery. After doing some cost/benefit analysis, I bribed my wife with a deal I thought she’d buy into – and she did! Our house sold almost immediately.

After we sold and began to rent, home prices continued to march higher. I couldn’t help but wonder if we (or I) made a huge mistake. Our rental was near the beach where the market was booming. Living in a real estate hot spot was a constant reminder of my poorly timed decision to sell.

My neighbor bragged to me about how he just paid off his car with his home equity line. A friend told me how much he was making on his third investment property. A banker literally laughed in my face as we debated the merits of housing. “You’re throwing your money away by renting,” he said. It was a difficult time to be a renter and nonbeliever in the perpetual housing boom.

Despite the seemingly endless real-time data points suggesting I had lost my mind, I firmly believed the economy, stock market, and housing market were all one giant bubble built on unsustainable credit growth. I was confident in the facts and my analysis. All I needed to do was be patient and survive the constant narrative from the media and financial markets that I was wrong and this time was different (sound familiar?).

In addition to selling our house and renting, I avoided bank stocks and allowed cash to build. Furthermore, I was careful not to extrapolate peak earnings of cyclical and consumer companies benefiting from the easy credit environment. Given how credit spilled over into many areas of the economy, profits for most industries were high and growing. Instead of normalizing profit margins and cash flows, investors appeared to be valuing businesses as if the good times would never end.

As a strong believer in economic, credit, and profit cycles, I was confident the excesses of the boom would ultimately result in a bust – it was only a matter of time. In addition to attempting to protect myself and clients from the risks of the housing bubble, I continued to spread the word to anyone who would listen.

I’ll never forget the day my wife and I were riding bikes and I noticed a realtor escorting buyers into a new luxury condo. Suddenly and unexpectedly, I yelled, “Don’t do it, it’s a bubble!” The look the realtor gave me was priceless! And my poor wife was so embarrassed, but not me. I laughed and laughed all the way back to our rental.

Of course, the end of the housing bubble wasn’t funny. When it imploded millions of people were hurt and many institutions failed. Just as with today’s asset inflation, the last cycle’s excesses were founded on easy money and the widely-held belief that prices would never be allowed to fall. There are many similarities this cycle versus last cycle and the cycle before it.

Given the parallels between the current market cycle and the past two, it’s logical to ask if we’re currently in another bubble. Depending on your preferred valuation measure, equities are as expensive (more expensive on some measures) than they were in 2000 and 2007. If valuations are similar or higher than past bubble peaks, how can today’s cycle not be considered a bubble?

Regardless of how the current market cycle is labeled, I’m confident my opportunity set is the most expensive it has ever been, including 2000 and 2007. As such, I’m comfortable calling small cap stocks a bubble, but more important, I’ve positioned myself accordingly.

While selling our house and renting worked very well during the last bubble, this cycle I’m more focused on avoiding overvalued equities than overvalued real estate. Although home prices currently appear expensive locally, I haven’t bribed my wife to sell our house again. There are several reasons. First, the only bribe she’d accept today would be moving into a bigger house! Second, we have kids now which makes moving less practical. And third, given the broadness of overvaluation this cycle, our investment positioning is different with a larger allocation to liquidity and patience.

Considering the potential risks of central bank asset purchases, I continue to believe holding some form of hard asset, such as real estate, makes sense (at least in our situation). Once earnings season concludes, I plan to write a post discussing one or two asset heavy companies on my possible buy list that may be interesting cash hedges. I recently bought one, added another to the list, and continue to consider others I’ve owned in the past. Having a barbell portfolio consisting mostly of liquidity and patience, combined with a cash hedge, or central bank insurance, seems rational to me. And if I can find a cash hedge trading at a discount to its net asset value, that’s even better. More to come in the following weeks…

Have a great weekend!


Coin Flip Investing

Have you ever worked on a stock and came to the conclusion it could either double or go to zero? I have and I did again last week. In an effort to limit mistakes and maintain an attractive batting average, as an absolute return investor, I try to avoid coin flip investing. During my resent search for discounts in the energy sector, I discovered the industry was filled with potential coin flips. CARBO, the market leading ceramic proppant manufacturer in the oil and gas industry, is a good example.

What’s worse than being in a commodity business? Selling a commodity to a commodity business. While I’m certain CARBO would argue most of their products are proprietary, they compete with a commodity known as sand. As energy prices declined in 2014-2016, energy and production companies looked for ways to reduce finding and development expenditures. In their effort to lower costs, many energy companies increased the use of sand in their fracking process. Furthermore, less expensive imported proppants were also threatening market share. In effect, CARBO faced stiffer competition from lower cost providers at the same time energy exploration budgets were being slashed. It was a devastating combination.

Prior to the bust, oil was trading near $100/bl (2011-2014), with exploration and production companies focusing almost exclusively on production growth. As oil prices traded well above all-in costs, companies were willing to pay for higher-end proppants to maximize production. Elevated oil prices also made higher cost reserves at lower depths economical. This benefited CARBO as their proppants are more effective at lower depths (higher pressure) than sand and lower quality proppants.

As Wall Street flooded the energy industry with cheap capital, the race to grow production was on – CARBO’s business was booming. Due to surging demand, CARBO expanded capacity aggressively with capital expenditures far exceeding depreciation during the boom years. CARBO was a popular growth stock, reaching $180 in 2011! Earnings also peaked in 2011, with EPS reaching $5.62 (CARBO is a good example of investors confusing cyclical growth for sustainable growth). Currently trading at $7/share and losing money (-$3.29 EPS in 2016), CARBO has seen better days.

Fortunately for CARBO, revenue trends are beginning to recover. With capital budgets and rig counts in North America increasing, the demand for proppants is improving. Recent results from the major service providers (SLB, BHI, and HAL) and CARBO confirm this trend. The below quotes are from last quarter’s earnings reports and conference calls.

Halliburton (HAL): “North America activity increased rapidly during the first quarter, which was highlighted by our U.S. land revenue growth of nearly 30%, outperforming the sequential average U.S. land rig count growth of 27%.”

Baker Hughes (BHI): “The ramp-up in North America has been more robust than many had expected. Along with this growth, we’ve had to work through the challenge of supply chain tightness, with labor and materials cost inflation [would include proppants] impacting select product lines and basins.”

Schlumberger Limited (SLB): “The recovery will clearly be led by North America land, where investment levels are expected to increase by 50% in 2017, leading to a strong increase in activity and an overdue correction to service and product pricing.”

CARBO Ceramics (CRR): “Given the first quarter revenue and our outlook for the next couple of quarters, we believe our 2017 revenue will show strong double-digit growth of at least 40% increase over the 2016.”

With CARBO’s net assets selling significantly below replacement value and its business trends improving, why wouldn’t I consider buying the equity? Unfortunately, in my opinion, CARBO possesses both financial risk and operating risk (disqualifies CRR as an absolute return holding). With $56 million in cash and $109 million in net working capital, the company should have adequate liquidity this year. Furthermore, the majority of its $73 million in debt was recently refinanced out to 2022.

While CARBO should have sufficient liquidity for 2017, if its cash burn rate remains negative (possible if energy cap ex budgets are cut), liquidity and financial risk could increase and is a concern. The company burned $24 million in cash in Q1 2017 after a $13 million negative free cash flow drain in Q4 2016. As you can see, at current rates, it wouldn’t take long for CARBO to spend its remaining cash and run into liquidity issues. Fortunately, management expects the company’s cash burn rate to improve sequentially and exit 2017 at a neutral rate (we’ll know more next week when CARBO reports earnings).

Given CARBO’s balance sheet risk (liquidity relative to cash burn) combined with its extremely cyclical business, it’s not an appropriate investment for my absolute return portfolio. That said, I’ve been pondering if several energy stocks, such as CARBO, would be worthwhile “coin flip” speculations for option strategies – owning puts and calls. In effect, a position that would pay off if things go great or awful (I’m expecting one or the other for CARBO). I’m certainly not an option expert (I often get the idea right, but the timing wrong!), and it would clearly be a speculation, but I think it’s interesting to think about nonetheless. As a side note, you know your opportunity set is bad when you’re contemplating ways to profit from a coin flip!

In conclusion, my search for value in the small cap energy sector has generated several possible buy ideas. While I believe there are many energy companies selling at discounts to net asset values, most balance sheets appear ill-equipped to handle an extended period of depressed commodity prices. In other words, there is value in energy, but is there sufficient liquidity or time for that value to be realized? Until balance sheets improve, I expect to find more coin flips in the energy sector than investments that meet my buy criteria for cyclical businesses.

Top Absolute Return Investing Posts

A little over a year ago I recommended returning capital to clients as I believed my opportunity set was too expensive to meet my absolute return investment objective. As a way to remain engaged in the markets and stay on top of my 300-name possible buy list, I decided to start a blog. This week marked the blog’s one year anniversary!

After 155 posts, I’ve practically written a book on absolute return investing and the current investment environment. I’ve enjoyed it considerably and plan to keep going until this seemingly endless market cycle is complete.

This week is also my one year anniversary of unemployment. Considering the unemployment rate is at a 16-year low, not having a job these days truly is contrarian! It took me a few months to detox from the markets, but it’s been a very good break. I’d like to thank all the central bankers for their $12 trillion in asset purchases and negative real interest rates. Without their relentless devotion to monetary experimentation and record asset inflation, I’d probably still have a job!

In all seriousness, it’s been a good year. I want to thank everyone for reading and helping me remain involved in what has to be one of the most fascinating cycles in the history of financial markets.

If you’re an absolute return investor – even if you’re trapped in the relative world – I hope this blog has provided some support and has reinforced your convictions. I’ve been pleasantly surprised by how many investors share the absolute return mindset. In fact, our community has grown considerably over the past year.

For newer readers and to mark the blog’s one year anniversary, I put together a list of most popular posts. I hope you find them interesting and thanks again for reading!

Top Ten 18 Absolute Return Investing Posts:

  1. Parachute Pants
  2. Is This Investing?
  3. Buffett 1999 vs. Buffett 2017
  4. Loyalty, Prudence, and Care
  5. The Art of Looking Stupid
  6. What’s Important to You?
  7. The Wonder Years
  8. The Small Cap Police
  9. Category 5 Asset Inflation
  10. Look Away I’m Hideous
  11. The Passive Investor (PI) Ratio
  12. Monetizing Cats
  13. Special Dividends
  14. 95% Undateable
  15. I’ll Be Gone You’ll Be Gone Central Banking
  16. The Mullet Discount
  17. Mo’ Margins Mo’ Problems
  18. Investment Closers

Earnings season, or my busy season, is approaching. As such, I may not be posting as frequently over the next two to three weeks. I’m looking forward to gaining timely data points on the profit cycle and economy. I hope to share my observations and conclusions soon!

Patience – A Possible Win-Win

Investors long patience, or cash, are finally benefiting from asset inflation. As buoyant markets and low volatility allow the Federal Reserve to begin its normalization process, interest rates on cash and cash equivalents are on the rise. The three month T-Bill is yielding 1% while various savings accounts and cash equivalents are providing yields slightly over 1%. It’s not much, but for investors waiting for higher returns on their savings, patience is finally beginning to pay (side note: it may be a good time to check yields on cash to make sure you’re not getting shortchanged).

We’re in an interesting part of the market cycle for stocks and bonds. For most of this cycle, stocks and bonds have simultaneously enjoyed the wonders of 0% interest rates and central bank asset purchases. Things are changing. While I question the perception that the Federal Reserve has turned “hawkish” (short-term real rates remain negative), as long as financial conditions remain stable and equity prices inflated, the Fed will most likely continue raising rates. In effect, until something in the financial markets “breaks”, the Fed’s tightening path appears to be on a set course. Remember, they want to be transparent, predictable, and avoid sudden shifts in policy.

As stated in a recent post, the Fed’s plan to gradually raise rates reminds me of Greenspan’s attempt to exit from his extended period of easy money. During the second half of the Greenspan-Bernanke cycle (2002-2008), monetary policy was tightened consistently until the stock market crashed and the U.S. economy entered a severe recession. Is the Fed on a similar late-cycle path today? If so, I believe it’s possible patient investors will be rewarded regardless of whether stocks rise or fall.

Exactly when the current market cycle ends remains unclear, but in my opinion, the cozy relationship between short-term interest rates and equities is over. Going forward, higher stock prices will most likely lead to higher short-term rates. This changing relationship could be a win-win for patient investors. For instance, if stock prices remain inflated, I expect the Fed will continue to raise rates, giving patient investors a higher return on their cash. Alternatively, if higher rates cause the market cycle to end abruptly, patient investors would benefit from the avoidance of capital losses and lower stock prices.

While I continue to miss out on the all-too-easy gains in the stock market, I remain committed to my absolute return discipline and its requirement to remain patient during periods of overvaluation. Waiting isn’t easy, but with short-term interest rates trending upward, it’s gotten a little easier. As the later stages of the current market cycle unfolds, I believe patient investors will likely be rewarded with either higher returns on their liquidity or a more attractive opportunity set. After years of punishing 0% returns on cash and few genuine discounts to value in equities, I view both outcomes as refreshing and potentially very rewarding.

Please keep those rate increases coming!