Retail Survivor

Last week I worked on DSW Inc. (DSW), the shoe retailer. I often think of DSW as the Home Depot of footwear. For a shoe retailer, their stores are huge, averaging 21,000 square feet and carrying 22,000 pairs of shoes. I’m a former shareholder and customer of the company. DSW has been on my possible buy list for over a decade. Although I do not own DSW at this time, rising retailer pessimism and DSW’s declining stock has increased my interest.

DSW’s stock traded below $17/share last week after reporting earnings. Similar to many retailers, DSW’s operating results were on the weak side with same-store comps declining 3%. Gross margins also declined (180 basis points), partially due to an added rotation of “clearance activities”. Although same-store comps and margins declined, the company maintained its earnings guidance of $1.45 to $1.55 for the year. However, management noted they expect sales comps to be near the low-end of their prior guidance.

Management made a few comments on their quarterly conference call that caught my attention. Specifically, management noted that while the environment is challenging, they expect DSW to survive the ongoing consolidation in retail. In effect, as competing stores close, DSW expects to gain market share. That’s the good news. Of course the bad news is initially store closures, along with tepid and inconsistent consumer spending, could lead to further inventory mark-downs, liquidations, and margin pressure.

In my opinion, the great retail washout could eventually lead to some interesting investment opportunities, especially for survivors with strong balance sheets. I consider DSW’s balance sheet to be healthy and liquid with $254 million in cash, $533 million working capital, and no debt (excluding leases). At this time, I agree with management. Assuming the company does not get overly aggressive on buybacks, dividends, store openings, and acquisitions, I believe DSW will be a survivor. While balance sheet analysis will help investors predict which retailers will remain in business, I believe margin and normalized free cash flow analysis will determine what the winners of “retail survivor” are ultimately worth.

During the last recession and the end of its last profit cycle, DSW’s operating income declined sharply from $100.7 million (7.9% EBIT margin) in fiscal 2007 to $42.8 million (2.9% EBIT margin) in fiscal 2009. In its current profit cycle, operating margins have ranged from approximately 3% to 10% (peaking in 2012-2013; currently near 7%). What will DSW’s normalized revenues and margins be after the majority of its weaker competitors go bankrupt or consolidate? Answer this question and I believe you can determine if an investment in DSW’s equity will generate adequate future absolute returns.

Normally I prefer buying consumer discretionary businesses in recessions. During economic downturns, investors often extrapolate weak operating results too far into the future. While I often talk about extrapolation as a risk, investor extrapolation can also lead to excessive pessimism and opportunity.

The last time I felt a group of stocks suffered from excessive pessimism and presented opportunity was in 2013-2015, when the precious metal mining stocks were annihilated. Near their lows, precious metal equities were simply too embarrassing and contrarian for most professional investors to own. For those willing to assume perception and career risk, miners represented wonderful opportunity, in my opinion.

As investor sentiment on retailing stocks turns increasingly negative and the retail shakeout progresses, will the retailers of 2017-2018 eventually resemble the miners of 2013-2015? While I don’t believe the retailers are nearly as inexpensive as the miners near their lows, it’s a group I plan to monitor and study more closely.

While growing pessimism and declining equity prices may eventually create opportunity, the retailing industry has historically been filled with value traps (admit it, you know you worked on Radio Shack!). I prefer avoiding overused phrases, but absolute return investors will need to be very selective, especially as it relates to financial strength. Similar to the miners, I believe it will be very important to focus on consumer discretionary stocks with strong balance sheets given the cyclicality of their businesses.

As stated in past posts, I believe it’s important to avoid combining operating and financial risk – it’s one of the easiest paths to bankruptcy. Remember, as absolute return investors, we want to avoid buying stocks that eventually resemble goose eggs. I believe avoiding retailers that bought back stock with debt may also be a good idea, or at least considered a red flag. I’m hesitant to own businesses with boards of directors that do not share my beliefs regarding operating and financial risk or that placed unnecessary strain on balance sheets in an attempt to reach EPS goals.

Lastly, if retailers eventually become as disliked as the precious metal miners, it’s important to understand these are two very different investments. The margin of safety of the precious metal miners came from their hard assets and inventory in the ground. Near their lows, investors could buy high-quality miners at significant discounts to the replacement cost of their long-lived assets. The assets of most retailers are not nearly as “solid” or as difficult to replicate. For instance, I have little interest in owning stores or warehouses of depreciating pants, sandals, and sweaters selling at 0.5x book value. As such, most retail valuations should be calculated by discounting normalized free cash flow, with cash coming from profitable operations, not inventory liquidations.

It’s an interesting market cycle. While equity valuations are expensive and overvaluation is very broad, there have been bear markets within sectors such as energy, precious metal miners, and certain areas of retail. In addition to creating possible opportunity, rotating sector bear markets are a refreshing reminder of how free markets and capitalism are meant to function – some companies survive and some do not.

As the great retail shakeout unfolds, I hope to identify and accurately value many of the survivors. Whether or not prices cooperate and provide investors with sufficient opportunity remains to be seen. Nevertheless, I find the negative trend and sentiment in retail stocks encouraging, especially for absolute return investors shopping for lower asset prices!

Hop on the Bus, Gus

As the stock market declined last week, I was riding in a school bus filled with third graders. As we headed to a museum, I looked out the window and couldn’t help but appreciate how fortunate I was to be on a bus with laughing children instead of sitting in an office behind a Bloomberg. I knew if I was still managing a mutual fund, I’d be spending most of my days desperately searching for value in one of the most unattractive opportunity sets in the history of financial markets. Instead of forcing myself to find value where valued doesn’t exist — also known as manufacturing opportunity — I continue to believe my best option is to remain patient and watch the market cycle run its course from a safe distance.

As an absolute return investor eagerly waiting for free markets and investing (as I define it) to return, I was encouraged by last week’s fall in equity prices. However, the brief and shallow decline didn’t cause me to get overly excited about discovering value in the near-future. Until the current market cycle ends and valuations normalize, I expect opportunities will remain scarce. As such, I find little benefit in monitoring the daily movements in the markets and asset prices, even when they are falling. The decline that will eventually get me interested in allocating capital will most likely be considerably greater than Wednesday’s 1-2% hiccup (the past two cycle declines of 40-60% should suffice).

While I find the prices of most risk assets uninteresting, I continue to monitor the results and fundamentals of hundreds of publicly traded operating businesses. For my process and strategy to work, I need to be prepared to allocate capital at a moment’s notice. As seasoned investors know, the market cycle isn’t obligated to provide us with a formal notice or catalyst of its eventual demise. The abrupt ending of the internet stock bubble is a good example. When that cycle’s speculation bill arrived on March 10, 2000, it was unexpected, hefty, and due immediately. The decline was simply a result of an extremely overvalued market that stopped going up — that’s all it took.

Instead of watching investors buy the latest dip last week, I used my time to get caught up on consumer company earnings reports and conference calls. Earnings were mixed with some consumer companies reporting better than expected results, while others remained weak. Overall, in my opinion, the consumer environment has not changed meaningfully. For companies further removed from asset inflation, same-store sales comparisons remain in the low positive to negative single-digits — it’s stagnant. As I noted in a previous post, unless the consumer can rebound, I expect the recent bounce in aggregate earnings to lose steam later this year (easy comparisons with energy and industrial companies will begin to fade in Q3/Q4).

Below are some highlights of recent earnings reports and conference calls.

Wal-Mart (WMT) seemed to dazzle investors with its 1.4% same-store sales comparison and 1.5% increase in traffic (Wal-Mart U.S.). Management mentioned the delay in tax refunds was partially responsible for the slow start to the quarter and that sales trends improved throughout the quarter. Sales were also aided by the company’s investment in e-commerce. Specifically, Wal-Mart introduced free two-day shipping for purchases of $35 or more and began a pickup discount for products ordered online and picked up in the store. Wal-Mart also invested in lower prices. Despite these investments, gross margins were flat partially due to “savings from procuring merchandise”. While squeezing suppliers to help fund investments in e-commerce and lower prices seems to be working in the near-term, is it a sustainable strategy?

Target’s (TGT) comparable sales were also in the low single-digits, but negative with Q1’s comps declining -1.3%. The decline came from lower traffic (near 1% drop) and average ticket. Management called the environment volatile and does not believe conditions will change soon. Unlike Wal-Mart, Target was unable to avoid lower gross margins (down 40 bps) from its investment in e-commerce. Inventory was noticeably lower, down 5% from a year ago. Management believes competitor closings will continue to be disruptive and is planning for another low single-digit decline in comps in Q2.

After recently lowering earnings expectations, Foot Locker (FL) announced actual results last week. Operating results and guidance were less than expected, causing Foot Locker’s stock to decline -17%. Specifically, Foot Locker announced comparable sales declined -0.5%. Due to lower than expected April results, EPS of $1.36 was near the low-end of the company’s revised outlook. Management is now expecting low single-digit comparable sales and flat earnings in Q2.

I remember last month being surprised that Foot Locker’s stock actually increased on the day it announced weaker than expected results. I discussed this in a recent post (link). I believe the stock’s positive response was due to management’s optimistic comments regarding an improving April (a things are bad, but they’re getting better preannouncement theme). While April’s results were strong, increasing in the high single-digits, they were lower than management’s expectation of a double-digit rebound. Hence, the sharp decline in its stock price.

Foot Locker’s guidance was also less than expected. The company is now forecasting flat earnings and low single-digit Q2 comps. Management mentioned they are now considering “Plan B” (reducing inventory and expenses) to achieve their earnings goals. Similar to several other consumer companies, management believes the delay in tax refunds was partially responsible for negative traffic and the slower than expected start of the year.

Although Dick’s Sporting Goods (DKS) earnings release was slightly better than Foot Locker’s, results and guidance were less than expected. Specifically, same-store sales were up 2.4%, while transactions increased 0.8% (1.6% driven by increase in ticket). Management noted, “Due to our slower sales in the first quarter as well as the potential for short-term headwinds from Gander Mountain’s liquidation sales and broadened distribution of product from a key vendor partner, we now expect consolidated same-store sales to increase between 1% and 3% for the year. This compares to our previous guidance of 2% to 3%.”

Interestingly, management did not blame the delay in tax refunds stating, “Yes, I know people have talked about tax refunds. I don’t really — I’m not sure that tax refunds had much of an impact.” Management also made some interesting comments as it relates to real estate saying, “With what we see with so many stores that are closing or purported to close or we expect will close, there’s going to be just a flood of real estate on the market. Our view is that we should not be opening a whole lot of stores right now because we’re going to pay a higher rent today than we would 2 or 3 years from now.” In effect, management plans to be patient and wait for better opportunities – respect.

One of my favorite retailers (for shopping, not investing) is Stein Mart (SMRT). Stein Mart reported comparable sales for the first quarter declined -7.6%. Management noted, “We continue to experience traffic weakness that we have not seen since the 2008/2009 recession.” Management also commented that it is observing a dramatic change in consumer shopping behavior. As a result of the difficult operating environment, Stein Mart is conserving cash and cut its dividend. Similar to Dick’s, Stein Mart does not believe “tax returns had any impact on our particular customer base.”

Home Depot (HD) continues to report strong operating results with same-store comps increasing 5.5%. However, transactions only grew 1.5% with average ticket increasing 3.9%. Inflation in lumber, building materials, and copper positively impacted ticket growth by 0.75%. Furthermore, comps continue to benefit from big-ticket sales with transactions over $900 up 15.8% (20% of sales are classified as big-ticket).

Dependence on large ticket sales works both ways, depending on where we are in the cycle. Currently, with home prices rising, the cycle is clearly up. Management noted home prices increased 5% year-over-year and they see continued growth in residential investment. Management also stated, “There are 76 million owned households in the United States. And of those, there are only 3.2 million that have negative equity in their home. And you go back to 2011, 11 million of those households had negative equity in their home. So the amount shows that since 2011, homeowners have enjoyed a 113% increase in wealth, if you will, coming from home price appreciation. So on average, $50,000 per household. So you can imagine, at some point, to Ted’s point, they’ll take that down out and do a bigger millwork or a total remodel job.”

Kohl’s (KSS) had another weak quarter with comparable sales declining -2.7%. Kohl’s continues to pursue the strategy of lowering inventories with inventory units per store declining -5%.

Ralph Lauren (RL) is taking Kohl’s strategy of lowering inventory a step further. In its effort to align inventory with demand, inventory declined 30% versus last year! Results were weak, with North America revenue declining -21%. The company’s decision to reduce inventory is expected to improve full-price selling, or reduce discounting. It’s an interesting and drastic strategy. I look forward to watching it play out. At the very least, with such sharp declines in inventory and sales (big bath), one can reasonably assume the sharp double-digit declines will eventually stabilize. At what level and at what margins is the unknowable, in my opinion, making any valuation with a high degree of confidence difficult. It will be an interesting case study in discovering the appropriate response to a rapidly changing retail environment and sluggish end demand.


Don’t Forget to Stretch

I recently pulled my hamstring and calf muscles. After informing a disciplined value investor of my misfortune, he said, “Stretching is key! Stretching is like the due diligence, listening to earnings calls, etc of working out. Doesn’t feel like you’re making any progress when you do it, but you will pay through the nose if you don’t.” How true!

Stretching is exactly how this earnings season felt. It didn’t feel like I was making a lot of progress — results weren’t very exciting or different from recent trends. Nevertheless, reviewing quarterly results and conference calls is almost always worthwhile as I usually learn something new about a business, industry, or current trends. Quarterly maintenance research is also an essential part of my investment process. Without reviewing quarterly results and calls, I’d have trouble determining where we are in the all-important profit cycle. In effect, I’d be lost from a micro and macro perspective.

Based on my bottom-up analysis, the current profit cycle remains intact. While the media touts this earnings season as the strongest in several quarters, it didn’t seem too dissimilar to me than Q4 2016. In my opinion, it was a relatively stable quarter with certain sectors rebounding from their 2015-2016 lows (energy and industrials benefiting from easy comps), while sluggishness continues in other areas of the economy (many consumer businesses).

As stated in past posts, I believe the hiccup in the current earnings cycle (2015-2016) was a result of the bursting of the energy credit bubble, and to some extent, the strengthening dollar. With the dollar’s strength subsiding and the energy industry rebounding, these trends, along with aggregate earnings growth, have reversed. The rig count bottomed last summer and has rebounded along with the energy industry’s spending on production and exploration. As such, barring a collapse in energy prices, I expect another quarter or two of easy comparisons.

Will we have another energy credit bubble? I’m not sure, but I definitely noticed a spillover effect from the rebound in energy investment this quarter. In fact, I believe it’s one of the main reasons aggregate earnings results continued to rebound. The return of capital and spending not only benefited energy companies, but many industrial, financial, transportation, consumer, and service companies. Furthermore, because drilling has increased without a strong jump in energy prices, margins in other industries have not suffered meaningfully from higher input costs. I put together the following charts of the rig count and corporate earnings (source: St. Louis Fed). Interesting, don’t you think?

The energy boom and bust was directly tied to easy credit. In my opinion, the energy credit bust was far-reaching and contributed to the broader slowdown in the economy, profits, and financial markets in 2015 and 2016. Of course, in hindsight, the decline in profits was temporary. With asset inflation and credit flowing again, the corporate profit cycle has resumed its upward trend. Whether the rebound is transitory — as the Fed likes to say — or something more sustainable is inconclusive, in my opinion. We’ll have to continue to watch for signs of changing trends. However, unless the consumer slowdown that I began to notice last September reverses, I believe corporate earnings comparisons and growth rates will become more challenging later this year.

Below is a summary of the Q1 2017 earnings season. Every quarter I put together company data and commentary that I find interesting and was helpful in forming my macro and profit cycle opinion. I included last quarter, but this quarter it was too long to post. If interested, shoot me an email.

  • The economy in Q1 was stronger than the government’s 0.7% GDP report indicated. Based on my bottom-up analysis, I believe Q1 economic growth was similar to Q4 2016, which came in at 2.1%. Operating results and tones were not recessionary, but were commensurate with slow to moderate economic growth. In aggregate, corporate earnings are positive and the current profit cycle is maintaining its upward path.
  • Industrial businesses, on average, had a good quarter. This is partially due to the rebound in spending within the energy industry, along with the stabilization of the dollar. Construction and aerospace were also solid.
  • Investment in domestic energy infrastructure (onshore) has rebounded sharply. Rig counts are up approximately 30% from a year ago. Considering many energy production companies have hedged a large portion of production in 2017, I expect the rebound in energy expenditures to continue. Easy comparisons for companies tied to energy spending should continue for at least 1-2 more quarters. Cost inflation is increasing throughout the industry. I expect the cost of exploration and production to grow – more capital will need to be raised. Offshore energy remains weak.
  • Auto manufacturing is plateauing to declining. Most businesses tied to the auto industry are aware of this and are not forecasting growth in 2017, but are also not forecasting a sharp decline. Will the auto industry and its credit boom witness a similar situation as the energy industry in 2015-2016 — a credit bust that spills over into demand and the broader economy.
  • Labor in certain industries, such as energy and services, is tightening. I continue to expect wage inflation to gradually become more noticeable in government data.
  • Outlooks and commentary suggest Q2 2017 should be similar to Q1 – slow to moderate growth (low single-digit sales growth), with the dispersion between industries continuing.
  • Outside of businesses directly benefiting from asset inflation, consumer businesses continue to report mixed and sluggish results. The consumer remains in a funk and is not aggressively spending outside of home improvement. The middle class continues to struggle.
  • Although weather was mentioned on several calls, it was not a major factor as has been the case in recent years (Q1s).
  • Several companies noted the first half of Q1 was challenging, while results improved in March. Delayed tax refunds, possibly.
  • Now that energy is no longer a drag, earnings ex-energy adjustments seem to have disappeared from quarterly results and earnings commentary (my post on ex-energy results: link). In my opinion, current equity valuations require growth well above and beyond easy comparisons.

The Passive Investor (PI) Ratio

I intended to complete my review of Q1 earnings reports and conference calls this week. Unfortunately, or fortunately, I was distracted by several stocks on my possible buy list that were in decline. Considering I’m eager to own equities again, I decided to postpone my maintenance research and work on possible buy candidates.

While several stocks on my possible buy list are down due to weak commodity prices, others declined as a result of disappointing operating results. Speedway Motorsports (TRK) is one of those stocks. Although Speedway’s operating results were in line with management’s expectations, revenues declined -3.5% during the quarter.  Management blamed weak revenue trends on the economy, underemployment, changing demographics, shifts in media entertainment consumption, and the absence of a stronger middle class recovery. While management maintained its earnings guidance for the year, its stock has fallen -12% since its earnings release.

Rarely do investors tout that they like slow growing businesses. Maybe you have, but I’ve never heard a portfolio manager on CNBC say, “We like boring companies with little if any growth.” It’s just not exciting television, nor is it good for sales! I don’t mind slow growing companies, especially if the business generates considerable free cash flow and has a well-defined capital allocation strategy. As long as the slow growth rate is properly considered in your equity valuation, I find nothing wrong with investing in a tortoise.

I expect Speedway Motorsports to remain a tortoise business as its struggle to generate organic growth continues. I believe attendance and event related revenue growth will remain particularly challenging. However, the stability and growth of its NASCAR broadcasting revenue should continue to help offset the softness in other areas of its business (at least until 2024). In fact, the growth and dependability of the broadcasting revenue has helped Speedway Motorsports generate consistent and meaningful free cash flow over the past several years.

Paying down debt is one of my favorite uses of free cash flow by a slow-growth business. There are several reasons why this makes sense. First, it’s tough to mess up debt reduction. There is an immediate and certain increase in the intrinsic value of the equity net of debt. Furthermore, declining debt reduces financial risk and improves operational and strategic flexibility. Greater flexibility and lower risk can also lead to a lower discount rate (higher multiple), increasing the value of the equity further.

Although Speedway Motorsports hasn’t grown noticeably over the past five years, its business generated $445 million in free cash flow (current market cap $715 million) since 2011. Speedway used its free cash flow for debt reduction, buybacks, and an above average dividend (current yield 3.4%). During a period when many slow-growth companies are eager to take on debt to make acquisitions, I’m impressed with management’s commitment to deleveraging its balance sheet. Speedway’s long-term debt has declined from $555 million in 2011 to $254 million in 2016 (debt to equity is down from 0.7x to 0.3x).

As I was getting caught up on Speedway’s fundamentals and putting together my valuation, I stumbled into a statistic related to its equity float that I found concerning. Specifically, I was surprised to see how much of the float was owned by index funds.

Speedway’s float is small considering insiders own 72% of shares outstanding. With 41 million shares outstanding, that only leaves 11.5 million shares for outsiders. Based on my classification and calculation, 50% of its float is owned by institutions that I consider passive investors (index funds and ETFs).

Many journalists and analysts have written about the shift from active to passive investing, but what about the impact this shift has on business valuation? Investors often apply a discount to companies that are illiquid, closely held, or have customer concentration. The large index fund ownership of Speedway’s float caused me to ask, should investors also apply a discount to equities with concentrated passive ownership?

Investors often look at an equity’s short interest ratio or institutional ownership, but what about passive investor ownership? I believe passive ownership as a % of float is an increasingly important ratio to monitor. I call it the PI ratio and will be monitoring it closely going forward.

As we know, passive investors are price insensitive. Do I want to own an equity with 50% of its float controlled by price-insensitive investors? In my opinion, the potential for a price-insensitive investor to cause a dislocation in the stock is a real risk. As the popularity of passive investing increases, price-insensitive risk grows, along with ownership concentration and PI ratios. And at this stage of the market cycle, I’m much more concerned about a price-insensitive seller than buyer (price dislocation risk to the downside).

From a valuation perspective, I find concentrated passive ownership to be a very interesting and important topic. Should active investors be compensated for assuming the risks of investing alongside price-insensitive investors? And if concentrated passive ownership is a risk, as I believe it is, what is the appropriate discount to apply to the equity? Is it 10%, 20%, or 30%?

To illustrate passive concentration risk, let’s assume equity valuations normalize and stocks decline 30-50%. How would flows into passive strategies respond? The rush into passive strategies could very well reverse, as investors frantically press their “next day same as cash” sell buttons in an attempt to reduce risk and raise liquidity.

If passive strategies that own Speedway Motorsports experienced a 10% outflow, it would require the funds to sell 575,000 shares, or two to three weeks of trading volume. If passive funds were able to participate in 50% of the stock’s average volume it would take approximately five weeks to reduce the position. Passive funds and ETFs are fully invested and do not hold meaningful cash balances; hence, they don’t have the flexibility to gradually sell assets to meet large outflows. Cash needed to fund outflows would need to be raised almost immediately. In such a scenario, the stock price would decline until a sufficient bid was found, which could ultimately lead to a large price dislocation.

There are many variables to consider when determining the impact passive investor concentration has on an equity’s value. In addition to determining the appropriate discount to apply, when should it be applied? What percentage of float ownership by passive investors is considered too high? These are good questions and considering passive investor concentration has never been higher, it’s difficult to come up with definitive answers.

Passive investor concentration risk and PI ratios are growing. I plan to pay close attention and will be reluctant to own equities with high passive ownership unless I’m being properly compensated. Assuming the equity of Speedway Motorsports continues to decline, I may become an interested buyer. That said, in order to assume the risk of investing alongside a concentrated group of price-insensitive investors, I will adjust my equity valuation accordingly and demand an appropriate margin of safety.

Bernanke Touchdown Dance

One thing I learned about being a portfolio manager who is often in first or last place relative to his peers, is it’s usually not a good idea to tout performance, especially before the market cycle is complete.

Considering absolute return investors are required to refrain from speculating during periods of overvaluation, one should expect periods of significant relative underperformance in every market cycle. Staying focused on full-cycle performance is important — touting or judging performance before a complete cycle is premature and can result in lost credibility.

Speaking of judging performance before a complete cycle (in this case the credit, monetary, and economic cycles), the following is from CNBC today.

Steve Liesman: Bernanke is generally upbeat about the Fed’s ability to exit from easy monetary policies, saying its critics have been wrong in the past.

Bernanke: So far so good. You know, it wasn’t too long ago when people on shows like this were saying we were going to be having hyperinflation and huge stock market bubbles, and dollar collapse, and all kinds of terrible things to come, but in fact, it’s gone pretty smoothly. The Fed is in the process of exiting from easy money, the economy is doing pretty well, the unemployment rate is 4.5%, inflation is close to the Fed’s target. All those things are on track.

I’m reminded of Bernanke’s comments near the peak of the housing bubble when he was asked what he thought the worst case scenario would be if home prices declined substantially.

Bernanke:  Well, I guess I don’t buy your premise. It’s a pretty unlikely possibility. We’ve never had a decline in house prices on a nationwide basis…I don’t think it’s going to drive the economy too far from its full employment path.

Whether you’re a central banker or portfolio manager, I believe it’s very important to know where you are in the credit, profit, and market cycles. Making the assumption current conditions will continue indefinitely and cycles will remain incomplete carries considerable risk.

In my opinion, a better time for Bernanke to tout central banker performance is after rates and the Fed’s balance sheet normalize, or after the current monetary cycle is complete. Once emergency monetary policies are removed and free markets return, I believe we’ll be in a better position to not only judge the effectiveness of the Fed’s actions this cycle, but investors as well. Until the current cycle is complete, judging a central banker or portfolio manager’s 1, 3, 5, and even 7 year performance seems inconclusive (includes only the upside of the cycle).


A Fair Assessment

It’s been a very busy earnings season. While keeping up with the operating results of 300 companies is always a challenge, I find it helpful in determining where we are in the profit cycle (important when normalizing cash flows).

I’ve reviewed approximately 1/3 of my possible buy list. To date, it appears earnings are coming in as I expected and are slightly better than today’s 0.7% GDP report suggests. The operating environment isn’t great, but it’s not bad either. I thought the following exchange on Forward Air’s (FWRD) conference call sums up earnings season well.

Analyst: And then just to summarize the totality of your comments earlier. The economy is okay, probably growing a little bit. You don’t expect it to accelerate too much, but don’t see it getting any weaker. Is that fair?

CEO: I think that’s very fair.

I should have a thorough review of earnings season and management commentary next week. Have a great weekend!

Living the Minivan Dream

I apologize for not posting lately. Our kids are in full throttle school and activity mode, which has limited my time to post. I should be back to my old schedule in June once the kids are out of school and their baseball and softball seasons end (unemployment has really helped my kids’ swings!). Until then, I plan to spend most of my work-related time keeping up with my 300 name possible buy list. My backlog of topics to discuss is growing and I’m looking forward to posting more soon.

Today I wanted to briefly write about earnings season. Although it’s very early, results appear to be coming in as I expected. I don’t believe this earnings season will be a catalyst for the bulls or bears. In my opinion, it appears to be more of the same — similar to the past couple of quarters. As I touched on in a previous post, after several consecutive quarterly declines in 2015-2016, the current profit cycle has stabilized. In my opinion, the profit cycle was revived after the drag from the energy credit bust and strong dollar ran its course. Relentless asset inflation – resulting from reassurances from central bankers that global QE will be forever a part of our lives – most likely played a role as well.

While I’m not expecting major changes in operating results this quarter, this doesn’t mean I believe it’s safe to invest in overvalued equities. Price, of course, is the main determinant of future returns and at today’s prices, expected future returns remain well below my absolute return hurdle rates. Therefore, I continue to wait and watch and then wait some more. It’s a very boring part of my absolute return investment process, but essential.

Although earnings shouldn’t be too surprising in aggregate, I continue to expect dispersions between industries. Energy, industrials, and other cyclicals should continue to see some signs of improvement (1-2 more quarters of easy comparisons). Meanwhile, I’m expecting operating results of consumer companies (outside of those closely tied to asset inflation) to remain uninspiring. A good example is Foot Locker (FL). Yesterday the company announced its first quarter earnings will be equal to slightly below last year’s earnings. Management blamed the delay in tax refunds. Instead of declining, Foot Locker’s stock actually increased sharply, as management stated its sales rebounded from a weak February (they also acknowledged the rebound did not fully offset the slow start to the quarter). Regardless of the actual impact tax refunds had on the purchase of sneakers (???), based on the sharp rise in Foot Locker’s stock, the market is apparently in a very forgiving mood. I suppose it is a refreshing change from blaming the weather!

As I’ve stated in past posts, I consider most retailers to be cyclical businesses. And some, such as Foot Locker, can be very cyclical. Below is a ten-year chart of Foot Locker’s operating margins. I actually owned Foot Locker in the past. Can you guess when? If you guessed when operating margins were 1-3%, you’d be correct. At that time (during the last recession), I did not believe depressed operating margins would stay depressed indefinitely. Similarly, 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.

As is the case with most cyclical businesses, I believe normalizing profit margins for consumer discretionary businesses is very important and provides investors with a more accurate and stable valuation calculation. In my opinion, investors currently finding comfort in “only” paying 15x earnings for Foot Locker should consider performing a full-cycle scenario and margin analysis. Assuming a full-cycle operating margin of 7%, investors are actually paying closer to 30x normalized earnings for a cyclical retailer, not 15x.

Foot Locker investors aren’t the only ones incurring significant extrapolation risk these days. Many operating businesses have similar profit margin charts this cycle. In my opinion, one of the many aggressive assumptions investors are making this cycle is that record profits and margins will remain elevated indefinitely. I’ve refused to make the same assumption. In fact, my unwillingness to extrapolate current profit margins has contributed to my decision to go all-in on patience. I continue to believe in the business cycle and the factors that have historically influenced profit margins have not been abolished.

Out of curiosity, I pulled up Foot Locker’s “Risk Factors” listed in its 10-K near the last profit cycle peak (2007) and compared it to the list in its current 10-K (2017). According to Foot Locker, the number of risks to its business has actually increased from 9 near the peak of its last profit cycle to 28 currently. In other words, the risks to future cash flows (or at least the disclosed risk) has increased, not decreased as its equity valuation suggests. See below. Have a great weekend!

2007 Foot Locker Risk Factors (P/S Valuation: 0.6x sales)

  1. The industry in which we operate is dependent upon fashion trends, customer preferences and other fashion-related factors.
  2. The businesses in which we operate are highly competitive.
  3. We depend on mall traffic and our ability to identify suitable store locations.
  4. The effects of natural disasters, terrorism, acts of war and retail industry conditions may adversely affect our business.
  5. A change in the relationship with any of our key vendors or the unavailability of our key products at competitive prices could affect our financial health.
  6. We may experience fluctuations in and cyclicality of our comparable store sales results.
  7. Our operations may be adversely affected by economic or political conditions in other countries.
  8. Complications in our distribution centers and other factors affecting the distribution of merchandise may affect our business.
  9. A major failure of our information systems could harm our business.

2017 Foot Locker Risk Factors (P/S Valuation: 1.3x sales)

  1. Our inability to implement our long-range strategic plan may adversely affect our future results.
  2. The retail athletic footwear and apparel business is highly competitive.
  3. The industry in which we operate is dependent upon fashion trends, customer preferences, product innovations, and other fashion-related factors.
  4. If we do not successfully manage our inventory levels, our operating results will be adversely affected.
  5. A change in the relationship with any of our key suppliers or the unavailability of key products at competitive prices could affect our financial health.
  6. We are affected by mall traffic and our ability to secure suitable store locations.
  7. We may experience fluctuations in, and cyclicality of, our comparable-store sales results.
  8. Economic or political conditions in other countries, including fluctuations in foreign currency exchange rates and tax rates may adversely affect our operations.
  9. The United Kingdom electorate voted to exit the European Union in a referendum, which could adversely affect our business, results of operations and financial condition.
  10. Macroeconomic developments may adversely affect our business.
  11. Instability in the financial markets may adversely affect our business.
  12. Material changes in the market value of the securities we hold may adversely affect our results of operations and financial condition.
  13. If our long-lived assets, goodwill or other intangible assets become impaired, we may need to record significant non-cash impairment charges.
  14. Our financial results may be adversely affected by tax rates or exposure to additional tax liabilities.
  15. Changes in tax laws could materially affect our financial position and results of operations.
  16. The effects of natural disasters, terrorism, acts of war, and public health issues may adversely affect our business.
  17. Manufacturer compliance with our social compliance program requirements.
  18. Complications in our distribution centers and other factors affecting the distribution of merchandise may affect our business.
  19. We are subject to technology risks including failures, security breaches, and cybersecurity risks which could harm our business, damage our reputation, and increase our costs in an effort to protect against such risks.
  20. Risks associated with digital operations.
  21. The technology enablement of omni-channel in our business is complex and involves the development of a new digital platform and a new order management system in order to enhance the complete customer experience.
  22. Our reliance on key management.
  23. Risks associated with attracting and retaining store and field associates.
  24. Changes in employment laws or regulation could harm our performance.
  25. Legislative or regulatory initiatives related to global warming/climate change concerns may negatively affect our business.
  26. We may be adversely affected by regulatory and litigation developments.
  27. We operate in many different jurisdictions and we could be adversely affected by violations of the U.S. Foreign Corrupt Practices Act and similar worldwide anti-corruption laws.
  28. Failure to fully comply with Section 404 of the Sarbanes-Oxley Act of 2002 could negatively affect our business, market confidence in our reported financial information, and the price of our common stock.


C’mon Man!!!

There are many potential risks and rewards associated with attending a small college. Given my current patient and prudent positioning, I’d like to remain focused on the risks. There is one risk in particular that my high school counselor neglected to share with me. It’s a significant risk that I didn’t fully appreciate until after I enrolled in my small college of choice, Stetson University. It’s a risk and sacrifice I endured throughout my college career and for most of my adult life. I’m referring to the risk of loss — in fun and excitement — associated with missing out on big-time college football games.

As with most risks, there are ways to hedge. A popular small college hedging technique is adopting another team as your own. For example, most of the Stetson University alumni I know root for University of Florida, Florida State, or University of Miami. While adopting another college team may suffice for some, it doesn’t have the same fandom feel that comes with attending the school or being an alumni.

Another option for small college students and alumni is shifting their game-day focus from Saturday to Sunday. In other words, become an NFL fan. This is the option I selected after graduating from college and moving to Jacksonville, Florida. Shortly after my arrival, the city of Jacksonville was awarded an NFL franchise. Since I didn’t have a college team I could legitimately root for, I eagerly adopted my new NFL team, the Jacksonville Jaguars.

The Jaguars were pretty good in the early years (first season 1995), making it to the AFC Championship in 1996 and 1999. Since then, the team really hasn’t done much. In fact, they’ve been pretty awful since 2008, suffering through a nine year playoff drought. Interestingly, the Jaguars losing streak started about the same time the Federal Reserve launched its Quantitative Easing (QE) program and the current market cycle began. It’s unfortunate, but I seem to be the only fan that has made this connection. To this day I have not received a single high-five after yelling my favorite chant, “End the Fed! Quantitative easing and the Jags losing streak is perfectly correlated!” I often wonder what will happen first, the Federal Reserve loses credibility and the current market cycle ends, or the Jaguars make it to the playoffs? I’m not sure, but thinking about either possibility brightens my day!

Similar to most NFL fans, I like to watch Monday Night Football. Before the game, I often watch ESPN’s Monday Night Countdown. A popular segment of the program is called “C’mon Man”.  During this segment, the ESPN crew reviews the most outrageous and often humorous NFL highlights of the week. If you haven’t seen the show, I provided a sample below.

C’Mon Man Link

I thought of ESPN’s “C’mon Man” while reading some of last week’s top financial news. At this stage of the market cycle, few things surprise me. As asset prices often write the financial news, I expect the outrageous and at times even humorous. That said, even I was caught off guard by the number of “C’mon Man” moments last week. While there were too many to discuss in one post (I try to keep to 1000 words or less), there were several I thought were worth highlighting.

My favorite of the week came from the FOMC minutes released on Wednesday. In the minutes, some Fed members expressed their concern about valuations, stating equity prices were “quite high”. Is this the same Fed that has kept the federal funds rate below 1% for over eight years, encouraging investors to chase yield and inflate valuation multiples?  Is this also the Fed that “fixed” the bond market by purchasing $3.6 trillion of mortgages and USTNs, lowering yields and providing speculators with “relative” valuation cover? And isn’t this the same Fed that has transformed QE into an accepted monetary tool for global central banks, with the ECB and BOJ continuing to buy hundreds of billions of public and private assets a year? And now some Fed members are concerned asset prices are “quite high” after they, along with other global central banks, have completed over $12 trillion in asset purchases? C’mon Man!!!

Federal Reserve members also discussed the possibility of shrinking their bloated balance sheet. It was only two quarters ago that the Fed was openly discussing expanding its asset purchases to include corporate stocks and bonds during the next downturn (See post: Fed Raises Facebook to Strong Buy). In September Reuters reported, “The Federal Reserve might be able to help the U.S. economy in a future downturn if it could buy stocks and corporate bonds, Fed Chair Janet Yellen said on Thursday.” The Fed has gone from discussing the possible benefits of buying stocks and bonds to now contemplating reducing its balance sheet. What has changed over the past two quarters? The economy must have improved, right? It has not. In fact, economic growth has slowed considerably from 3.5% in Q3 2016 to current expectations of less than 1% (the Federal Reserve Bank of Atlanta is forecasting 0.6% growth for Q1 2017). If it’s not the economy, what is driving the Federal Reserve’s balance sheet narrative? While GDP growth has slowed considerably over the past two quarters, the S&P 500 has actually increased from 2160 to 2355 and the Russell 2000 is up from 1251 to 1364. Is it possible that asset prices, not the economy, are the main determinant influencing monetary policy? If so, C’mon Man!!!

William Dudley of the Federal Reserve Bank of New York was also busy last week. According to Bloomberg (link) William Dudley stated, “Free college is a ‘reasonable conversation’ to have.” With student loans reaching $1.4 trillion, student debt is a growing problem. Another issue is fewer students are paying back their loans. While there are many possible explanations, the belief that student debt will eventually be forgiven must be a major contributing factor. With politicians frequently waving the free college carrot in front of voters, it’s difficult to blame students for believing their debts will be forgiven. Politicians discussing free college doesn’t surprise me, but central bankers who actually have the ability to make anything “free” with an effortless stroke of the QE pen? C’mon Man!!!

Also last week, Panera Bread (PNRA) announced it was going to be acquired by JAB Holding Co. for $7.5 billion. JAB paid 19x EV/EBITDA, 32x EV/EBIT, and 49x earnings. Wow! I suppose these sort of valuations can make sense for a business growing rapidly. However, based on Panera’s slowing revenue and earnings growth over the past three years, its concept appears to have matured considerably. Although extremely low interest rates can make almost any acquisition look appealing on a spreadsheet, 19x EV/EBITDA for a maturing business in a saturated, hyper-competitive, and slow-growth industry? C’mon Man!!!

And finally last week, there was the taunting of short sellers by Tesla’s CEO, Elon Musk. Overconfidence is extremely dangerous in business and investing. Not to mention taunting is bad for the karma balance (and no, you can’t replenish your karma balance with a secondary offering). Mr. Musk should know better. C’mon Man!!!

Considering the current investment environment, I’m certain there are many more outrageous and humorous financial market moments on the way. It will be difficult, but I’ll try to keep up!

With all kidding aside, at this stage of the market cycle, humor can be an effective tool in helping absolute return investors manage through their difficult and frustrating opportunity sets. Instead of taking some of the news and events too seriously, sometimes it’s better to just laugh and say, “C’mon Man!”

Earnings Season Approaches

I recently reviewed UniFirst’s (UNF) quarterly results. I thought it was a good summary of what I’m expecting this earnings season. Furthermore, while I have no idea what tomorrow’s job report will show, the uniform companies aren’t a bad place to look when analyzing employment trends. Cintas (CTAS) also announced earnings recently. Cintas reported solid results, but spent most of its conference call talking about its G&K Services acquisition. UniFirst discussed the current operating environment in more detail and generated results that I believe closely resemble the broader economy.

UniFirst’s core laundry business grew revenue 2.2%. A low single-digit growth rate is commensurate with a mature economic cycle and what I’m expecting for nominal GDP this quarter. Management noted its business is stabilizing, particularly in its energy-related markets. As I’ve stated in past posts, corporate earnings growth in recent quarters has been aided by easy comparisons in energy-related and industrial businesses.

As it relates to its energy markets, management stated, “UniFirst witnessed significant uniform wearer losses in the niche markets over the last couple of years that affected our top and bottom lines. But more recently, we’ve been seeing not only stabilization in these areas, but actually some slight gains in energy-related uniform wearers. It would be premature for us to project any future growth opportunities in these volatile markets, but these modest improvements in uniform wearers have been more than welcome to say the least.”

The rebound in energy-related business shouldn’t be surprising. According to Baker Hughes (BHI) the average rig count for February 2017 was 744, up from 683 in January 2017 and up 212 from 532 in February 2016 (a 40% increase from a year ago). With many exploration and production companies hedging a meaningful portion of this year’s production, I believe capital expenditure budgets for 2017 will remain relatively stable. As such, I expect easy comparisons in energy-related businesses to continue for the next couple of quarters (rig counts bottomed in May-June 2016).

UniFirst also noted they were optimistic as it relates to government and policy. Management stated, “We are also hopeful that with the new presidential administration, national employment levels and the overall economy will soon begin reaping the benefits as a result of its new policies and from loosening up some of the business-related regulations. So we are watching these areas very closely as we move forward to identify any potentials for additional business and related growth opportunities.”

Has growing optimism spilled over into improving business trends? “From the customer visits that we’ve been making over the last quarter, I think there’s a general business hopefulness that this gentleman and the President of the United States will spend some money on infrastructure and maybe military spending to get more jobs going, but everybody is kind of wait and see.”

On rising costs and wages management stated, “They really have been filtering in. I think a number of states have increased minimum wages. And although most of our employees are above those minimum wages, it does cause sort of a wage compression right up the chain. And so we’ve been moving and having to pay more to hire certain positions from the production level up through the service level.

Management also noted they expect pricing to improve after Cintas recently acquired G&K Services. When asked about the acquisition management said, “I think we’ll get a little more rationality on the pricing side.”

Management commented on the current operating environment, stating, “Yes. We would say we’re operating right now in more of a normal environment, which is not really a big pull from wearers, but it’s not a drag either, so sort of stable and that’s our assumption. Ron mentioned we are seeing some pockets of positive adds in some of the energy markets, but again not overly significant. So we don’t have anything built in that’s a big pull or tailwind.”

And finally, I thought the following comment related to the reduction in growth caused by lower energy-related sales was interesting. In effect, management believes lower energy-related sales reduced the company’s overall organic growth rate by 1% (from 3% to 2%). In my opinion, this is similar to what the overall economy experienced with a 1% reduction in GDP after the energy credit boom turned to burst (GDP was averaging 2-3% before the energy bust and 1-2% after).

Specifically, management stated, “What I will say is that we’re 2 quarters in now to really not having seen those reductions from the energy sector. And once we sort of get another couple of quarters through, we’ll sort of have annualized that impact…without some of those reductions, our organic growth probably would have been in about that 3% range” [currently growing 2% organically].

In conclusion, I’m expecting this quarter’s earnings season to be similar to Q4 2016, with slow to moderate earnings growth on average. I’m expecting organic sales growth and nominal GDP to remain slow, in the low single-digits. The economy isn’t in a recession, nor is it booming. I believe we will also continue to see a growing dispersion between industries. As noted last quarter, energy-related and industrial businesses will benefit from easier comparisons – some growth should be anticipated. I also expect consumer discretionary businesses will continue to struggle, with companies more closely tied to asset inflation, such as home improvement, performing better.

I will provide a more detailed overview of current operating trends as the facts and earnings reports roll in. Similar to last quarter, I’ll also try to put together a summary of company operating results. I know these summaries are long, but if you can find time to read them, I think you’ll find it worthwhile. I continue to believe economic data derived from hundreds of operating companies is more timely, accurate, and valuable than government data.

For those attempting to guess tomorrow’s job number, good luck! Given all of the adjustments made to the data, I have no idea what the government will report. However, based on the results of the uniform companies, I wouldn’t be surprised if the number shows some improvement, especially in wages. I continue to see wage pressures and have been curious as to why this hasn’t showed up in the government data. Maybe tomorrow…

[Update: Friday’s job report showed hourly wages increased 2.7% year-over-year]

The Economics of Different

I grew up in a small town outside of Louisville, Kentucky. I’m not even sure I’d call it a town – more like a zip code. We lived in a subdivision with 5-10 acre lots and gravel roads. Growing up on a gravel road had its challenges. Have you ever fallen off your bike on a gravel road? Ouch! Walking or running on gravel isn’t particularly pleasing either, with rocks consistently finding their way into your shoes. Dust was an issue too, along with bumps and potholes. But there were some benefits.

While waiting for the school bus, the kids on our street played a game that consisted of throwing rocks at a street sign. It was a simple and fun game. How many times could you hit the sign before the bus arrived? The street sign was long, but very narrow – it was a tough shot. Hitting the sign before getting on the bus was always a nice start to the day.

I thought of my old bus stop this morning after driving past a group of kids waiting for their school bus. Instead of playing games and throwing rocks, they were all staring down at their smartphones. No one was moving or saying a word – they were frozen. What were they so focused on? Were they texting each other? Were they reading my blog? I wasn’t sure, but it really made me appreciate my childhood and growing up on that old gravel road.

Whether throwing rocks at signs or gazing into smartphones, kids tend to do what other kids are doing. Little changes as we get older. In past posts, I’ve frequently discussed how career risk and groupthink influences investor behavior. The investment management industry is not alone in its tendency to conform. Look at every industry and you’ll often find companies mimicking and following each other. Whether it relates to management compensation, acquisitions, buybacks, leverage, and general corporate strategy, most companies herd together and think and look alike.

The energy industry is a good example. I’ve been following energy companies closely since 1996. One thing I’ve learned is if I know what one energy company is doing, I’m fairly confident in what the entire industry is doing. For instance, during 2006-2008 natural gas prices were elevated and the shale revolution was picking up steam. The industry was enthusiastically buying and drilling natural gas properties. Although two consecutive cold winters delayed the inevitable, eventually natural gas supply spiked and prices fell. Suddenly spending heavily on natural gas properties no longer looked nearly as attractive.

The price of oil did not follow the decline in natural gas, with oil trading above $90/bl for most of 2011-2014. In response, the energy industry moved together again, sharply curtailing natural gas exploration and production in favor of oil. As natural gas properties were abandoned, the industry rushed into oil rich basins such as the Bakken and Permian. Acquisition and acreage prices soared. Similar to the natural gas boom, the rush to drill for oil eventually caused production and supply to spike, which contributed to a sharp decline in oil prices. The energy industry responded in unison again, slowing production, drilling within cash flows, and selling assets and equity at depressed prices.

Imagine for a moment an energy company that acted differently over the past ten years. I can’t think of one, so imagination is important in this exercise. What if our imaginary energy company didn’t aggressively grow production and buy new properties during the natural gas and oil booms? What if this company didn’t take on considerable debt like its peers? Instead of using its cash flow during the booms to buy new properties and drill aggressively, what if our company let cash flow accumulate on its balance sheet. Instead of selling assets and issuing equity near the industry’s trough, what if our imaginary energy company used its strong balance sheet to opportunistically purchase distressed assets during the bust? In effect, what if our energy company didn’t conform and did the opposite of its peers over the past ten years? I think it would be in pretty good shape right now and would have created tremendous value.

The energy and investment management industries have several things in common. Both industries are highly cyclical, with long histories of extreme booms and busts. Participants in both industries also have a tendency to allocate capital based on unsustainable trends – extrapolation risk is elevated. While the investment management industry has not experienced the same volatility as the energy industry over the past eight years, I don’t believe the degree of cyclicality between industries differs meaningfully. For example, a decline in price to normalized earnings (pick your favorite cyclically adjusted PE) from 30x to 15x wouldn’t be too dissimilar from oil falling from $100 to $50. With all-in costs near $50/bl for many energy producing regions, $50 oil makes a lot more sense to me than $100, just as 15x normalized earnings would for stocks. In my opinion, investors currently paying 30x normalized earnings for equities are no different than a CEO of an energy company buying oil properties in 2011-2014 and extrapolating $100 oil.

Similar to our imaginary energy company we discussed earlier, let’s now imagine an investment management firm that refused to conform and invested differently. What if instead of firing its active managers and replacing them with robots and a passive mindset, the asset management firm encouraged independent and unique thinking? Instead of hugging a benchmark and remaining fully invested, what if the firm invested in a flexible manner that allowed its managers to sidestep future losses and take advantage of future opportunity? What if there was an imaginary investment management firm that was willing to lose assets under management if that’s what was required to remain disciplined? Similar to our imaginary energy company, I believe this asset management company would be in pretty good shape over a full industry cycle.

While positioning a business differently can be very difficult during certain stages of an industry’s cycle, it also can be very rewarding. Given the duration and extremes of the current bull market, I believe the economics of different will be particularly attractive and evident once this cycle inevitably concludes.