Scenario Analysis

I’m always thinking like a credit analyst. One of the reasons for this is the discount rate I use in my valuation calculation is part credit risk and part equity risk. I determine my required rate of return on equity investments by asking how much I’d demand to lend to a business, then I add an equity risk premium to that. Historically what I’d lend to a small cap business has been 6-9%, while my equity risk premium has ranged between 4-6%. After adding the two together, my required rate of return on small cap equities has been 10-15%. Since the inception of the absolute return strategy I manage, I’ve achieved my equity return goals, which ultimately is my investment objective — achieving adequate absolute returns relative to risk assumed.

When thinking like a credit analyst and performing credit work, I’ve found scenario analysis to be a very beneficial tool. Scenario analysis attempts to consider all of the possible operating results a business expects to generate in a variety of operating environments. Not only does this help determine if I’ll get my money back as a creditor (or stock doesn’t go to $0), it is also essential in determining the normalized free cash flows I use in my valuation model. In essence, by considering and averaging a variety of outcomes, surprises are reduced and equity valuations are more accurate.

Given current corporate bond yields and equity prices, I do not believe there is a lot of scenario analysis happening on Wall Street these days. If scenario analysis is being performed, it appears investors have eliminated the possibility of a recession from their potential outcomes. I do not believe recessions are extinct. Given the age and character of the current economic recovery, I believe a future recession is inevitable and should be included in any scenario analysis.

Considering how long it’s been since the last recession, it’s understandable why many investors may have forgotten how recessions significantly alter business operating results and the investment landscape. It might be healthy to remind ourselves what a recession looks and feels like. Instead of looking at old government economic data, I thought it would be more effective to look at a recession through the eyes of a business. Specifically, I’d like to focus on Hanesbrands (HBI), the leading provider of underwear and activewear.

On Monday I talked about a highly cyclical business, Kennametal. While I believe I can illustrate how a recession feels more dramatically with an industrial company like Kennametal, I want to emphasize that all businesses are correlated to the economy, not just highly cyclical companies. I think this is especially important today given the overvaluation and crowded positioning in high quality and less cyclical stocks.

Another reason I wanted to focus on Hanesbrands is something caught my attention during their recent conference call. Management mentioned that, “Roughly two-thirds of our debt is now fixed and we have a blended interest rate of approximately 3.6%.” The 3.6% interest rate really stood out to me. That’s amazing, I thought, even in today’s extremely easy credit environment. I suppose I’m a little more surprised than most as I vividly remember when Hanesbrands’ stock was trading at $2 during the last recession in 2009. Things were getting pretty dicey for them and the industry. They ultimately survived, but I’m surprised the scars weren’t more noticeable for newbie bond buyers lending the company money out to 2024 and 2026. In my opinion, given the low coupons on this debt, they’re either not performing a scenario analysis, or they aren’t including a recession as a real possibility.

Although Hanesbrands’ business is more stable than most, they were not immune to the last recession. Please join me in going down memory lane to Q1 2009. It was Hanesbrands’ last trough in operating results and the last U.S. recession. Instead of credit being thrown at them by investors only demanding an average yield of 3.6%, Moody’s was downgrading Hanesbrands’ debt and amendments were being made to loosen credit covenants. A business that is considered a stable consumer staple by some, reported sales declined 13% and EPS declined to -$0.20 vs. $0.38 due to “weak consumer demand related to the difficult economic and retail environment.”

The following is from Hanesbrands’ April 4, 2009 10-Q. It’s a thorough description of their operating environment and the last recession.

The ultimate consumers of our products have been significantly limiting their discretionary spending and visiting retail stores less frequently in the recessionary environment. We are operating in an uncertain and volatile economic environment, which could have unanticipated adverse effects on our business. The retail environment has been impacted by recent volatility in the financial markets, including declines in stock prices, and by uncertain economic conditions. Increases in food and fuel prices, changes in the credit and housing markets leading to the current financial and credit crisis, actual and potential job losses among many sectors of the economy, significant declines in the stock market resulting in large losses to consumer retirement and investment accounts, and uncertainty regarding future federal tax and economic policies have all added to declines in consumer confidence and curtailed retail spending. We also expect substantial pressure on profitability due to the economic climate, significantly higher commodity costs, increased pension costs and increased costs associated with implementing our price increase which was effective in February 2009, including repackaging costs.”

I know this is a lot to chew on, but I think this is important for several reasons. First, in my opinion, risk assets are priced as if the above operating environment will never happen again. Or if it does, those overpaying will see it coming and avoid the carnage by being the first ones out. I’m not so sure on both assumptions. I believe the above will happen again and I also believe everyone can’t be the first ones out. Premiums for assuming risk are necessary and should be demanded by investors, not ignored and forgotten.

Second, many investors are currently crowding into consumer stocks, like Hanesbrands, assuming they’ll be safe during the next recession. Given the prices investors are paying, I believe investors seeking shelter in low risk businesses are increasing risk, not escaping it. I think it would be a helpful exercise if investors reviewed company results during the last recession and considered similar scenarios when measuring risk and valuing risk assets. Just because a company is labeled or categorized as a consumer stock or “recession-proof” doesn’t mean they have been or will be. All companies are cyclical to some degree and no one is immune to major dislocations in financial markets and the economy.

Based on record stock prices and the absence of risk premiums, investors have clearly forgotten 2009 and how close many companies came to the edge. I think it’s important to remember the last recession and why it came about. During the last cycle, investors collectively believed in some really silly things and extrapolated those beliefs far into the future. I believe the same thing is happening this cycle, but the beliefs are even sillier (unwavering confidence in central bank policy and T.I.N.A. are two of my favorites).

Have any of the problems that created the last recession really gone away? Excessive leverage is what created the last recession. Considering debt levels are currently higher than last cycle, it seems within reason that the next recession could be of similar magnitude and even longer in duration. One scenario I see possible is the next recession will begin due to failure of unprecedented central bank monetary policies. If the next recession is caused from central bank policy failure, the creator of the next recession (they were also the creator of last recession) would be too impaired or too discredited to replicate the 2009-2016 “V” shaped market recovery and subpar economic recovery. If the next recession is lower for longer, how will corporate credit perform? If results are anything similar to the last recession, holders of 3%-5% yielding BB corporate debt may be in for a rude awakening.

Fake Rolex

Many years ago I was walking into a client meeting with a colleague. Right as we walked into the client’s office the sole of one of my shoes came completely off. I looked over at my colleague and he just shook his head in disgust and said, “Value managers.”

I guess I’ve never been one to pay up for attire. My favorite suits come from Stein Mart (SMRT). I can’t tell the difference between a nice suit and a $199 (was originally $599!) Stein Mart special. I don’t wear jewelry or watches either. But if I did I’d like a Rolex. Not to impress, but from my understanding they hold their value (another cash hedge). One thing is certain, if I paid up for a Rolex, I’d want the real thing.

Given the prices of stocks these days, investors are certainly paying up and then some. What are they paying up for and are they getting the real thing? I suppose they’re paying up for future growth, since prices make absolutely no sense based on current growth trends. While outlooks for organic growth don’t appear encouraging, easy comparisons should help businesses pull out of their earnings recession later this year.

A company we talked about in depth yesterday, Kennametal (KMT), should see their comparisons become easier over the next several quarters. This may be one reason why investors have driven Kennametal’s stock up from its lows – they believe the worst may be coming to an end. Other cyclicals and industrials should also start benefiting from easier comps.

Business is still challenging for many industrial companies, but assuming nominal GDP stays near 1-2%, business trends should show signs of stabilizing, albeit at a lower level. Kennametal is a good example. Business remains weak with organic sales declining 8% last quarter, but management noted inventory destocking by its customers appears to be easing.

Management stated, “End-market wise it’s really pretty tough out there across the range of end markets. I guess I would say on the industrial side — aerospace, maybe automotive to little bit of an extent, and infrastructure — pick your poison. Mining, commodities, the only positives I think are a little bit in the earth works kind of business, some on the construction side. Just general, it’s tough to get ahead of the prior-year.

The good news I think, as we look forward, is that we have a little bit easier comps to go against. But you know, one of the concerns we have is that while we’re calling our revenue to be basically flat year over year, we are not sure how confident for us to really be on that. So that’s in fact one of the reasons why we were a bit more aggressive on thinking about further cost reduction.”

The question for Kennametal investors (and investors of other cyclicals) is has the stock gotten ahead of the “good news” of easier comparisons. Management expects to earn $1 to $1.40 next year. That’s quite a big range, which implies a lot of uncertainty. Trading at $27.50/share and a balance sheet I’m not particularly comfortable with ($100 million 2017E free cash flow vs. $540 million in net debt), many beaten down cyclicals don’t look so beaten down these days.

While comparisons should get easier as we go through the second half, I think it’s important not to confuse real economic growth (real Rolex) with easy comparisons (fake Rolex). This also relates to earnings estimates. Although most companies beat earnings estimates again this quarter, overall results and demand were stagnant – similar to Q1. With GAAP P/E’s in the mid-20x range for many stocks (even higher if cyclically adjusted), stagnant growth isn’t going to cut it, no matter how earnings look relative to estimates.

Current equity valuations require growth above and beyond easy comparisons. In my opinion, growth needed to justify lofty equity valuations must come from a real increase in demand, not simply bounces off the bottom of an earnings recession. In other words, for valuations to make sense, stocks need a sustainable increase in economic activity to generate strong organic growth. Where will this growth come from? What industry is poised for a strong rebound in organic growth? If growth doesn’t rebound sharply, how can current valuations be justified? These are good questions that I can’t answer. Hence, my positioning.

The Wall Street Locust Swarm

When something can’t be found at our house, I’m usually accused of throwing it in the trash. I admit I don’t like clutter, but just because this is true doesn’t mean I throw everything away. Kennametal (KMT) is proof of this. Kennametal manufactures precision-engineered metalworking tools and components, surface technologies and earth cutting tools. Kennametal has been on my possible buy list for years if not over a decade. I’ve followed them for as long as I can remember, but I’ve never owned them. Given their highly cyclical business and tendency to take on debt, I don’t expect to own them in the near future. For me, they are the definition of investment clutter.

Why do I keep investment clutter on my possible buy list? There are times I follow companies with debt if it’s a business I like and would consider purchasing assuming debt is reduced. Kennametal fits this description. Deleveraging sometimes occurs when new management comes in with a different financial mindset and capital allocation plan. Other times existing management becomes so financially distressed, they scare themselves into paying down debt and swear off excessive leverage in the future. I also like following Kennametal because they sell to several important industries and provide good detail on their end markets (transportation, energy, aerospace, general engineering, and earthworks).

I often hear or read about how balance sheets have improved since the financial crisis. Maybe for a few mega caps this is true, but for the average company this isn’t what I’m observing. In fact, I think balance sheets are worse. The often cited McKinsey study supports what I’ve noticed from my bottom-up analysis. According to McKinsey global debt has increased $57 trillion since 2007 through Q2 2014. Corporate debt has grown from $37 trillion to $58 trillion.

Given slower than normal sales growth this cycle, many companies have resorted to financial engineering to enhance sales and earnings growth. Debt is often used to acquire, buy back stock, and pay dividends. Kennametal has done all three this cycle and yes, their debt has increased.

I’m not in favor of highly cyclical companies taking on debt. Cyclical companies are called cyclical for a reason – they have volatile operating results with exhilarating booms and terrifying busts. For example, Kennametal generated EPS of $3.83/share in 2012 and lost -$4.71/share in 2015 (large charges). Guidance for fiscal 2017 is $1 to $1.40. Pick a number, any number! In my opinion, volatile earnings and cash flows do not mix well with high debt levels and their associated fixed cash costs.

While I’d prefer to own a high quality stable business at a discount, there’s nothing wrong with investing in cyclical businesses. I’ve owned several high quality cyclicals in the past and follow many. In fact, their volatile operating results often create stock price volatility, which can lead to opportunity. However, when investing in cyclical businesses, I have some golden rules. First, never extrapolate the booms or the busts – normalizing cash flows for valuation purposes is essential.

Second, during booms you must sell – do not buy and hold a cyclical stock. Sounds easy, but booms can be so intoxicating that making a sound investment decision becomes increasingly difficult as the stock and your adrenaline soar (investing under the influence, so to speak). I’ve found highly cyclical businesses are usually very overvalued or undervalued, but rarely priced just right. Take advantage of the volatility and don’t get greedy. And if you miss the boom or sell early, do not fear, cyclicals are the home of second chances.

Third, I only buy cyclicals with strong balance sheets. Buying a cyclical at a discount is irrelevant if the business can’t survive the cycle. As I’ve said hundreds of times in presentations to clients, I never combine operating risk and financial risk — I’ll take one or the other, but never both. Absolute return investors cannot have investments go to $0. Doing so is a serious investment crime for an absolute return investor. Thankfully my record is clean!

Why do so many cyclical companies take on debt? Most cyclical businesses are in mature industries. Markets like energy, auto, mining, and aerospace typically grow in-line with nominal GDP over an economic cycle. Under pressure to generate growth, mature cyclical companies often turn to acquisitions to expand market share. This is usually where most cyclicals get into trouble. We saw this most recently in the energy industry. Exploration and production (E&Ps) companies acquired land and invested heavily in energy service capital expenditures. The industry’s debt levels exploded higher with several E&Ps now in bankruptcy.

Similar to what happened in the energy industry, acquisitions and heavy investments are often done during the peak of the cycle when cash flows and credit are most abundant. As excessive capital and credit chases limited deals, many companies are eager to and are encouraged to spend well beyond their means, driving up financial risk along with acquisition prices.

Kennametal is a good example. During their last earnings boom, they made a large acquisition and took on debt. In November 2013, Kennametal acquired TMB (producer of tungsten metallurgical powders, tooling technologies, and components) for $607 million. The TMB acquisition expanded Kennametal’s “presence in aerospace and energy end markets.” Goldman Sachs was the advisor. In 2012, TMB had $340 million in revenue, $37 million in operating income and $45 million in EBTIDA. So Kennametal paid 2x sales, 16x operating income and 13.5x EBITDA. These are very expensive valuation multiples for a cyclical business. Kennametal also paid well over book value as they took on a large amount of goodwill for the deal ($244 million).

Shortly after the acquisition, Kennametal announced it would take restructuring actions and expected charges of $40-$50 million resulting from the acquisition and higher than expected TMB inventories. Charges at Kennametal continued as the boom it was enjoying in 2012 turned into a bust (several of its end markets are now in recession). Kennametal took a pre-tax impairment charge to goodwill of $153 million in March 2015 and another impairment of goodwill in December 2015 of $375 million.

Another reason cyclicals take on debt is they generate considerable income and free cash flow during their booms. This sounds counterintuitive. Shouldn’t high profitability and strong cash flows reduce debt? It should, but excess cash flow is often considered excess capital that many shareholders believe should be returned to owners. Company board of directors are under considerable pressure to do something when cash builds. Excess capital built during a boom also gives boards and management confidence – often too much confidence – to invest, acquire, or return capital. Similar to investing, large capital allocation mistakes are often made at the top of a business cycle, not at that bottom.

I like the idea of returning excess capital to shareholders, but when highly cyclical companies distribute cash, they often return too much and can quickly go from capital surplus to capital deficit. Once boom turns to bust, some cyclical companies that were making acquisitions or returning capital to shareholders are suddenly forced to raise high cost capital in order to survive (recent equity issuance by energy companies after stocks declined sharply is a good example). Insufficient capital and liquidity during busts can also cause businesses to be managed too defensively and can frighten away customers due to service or counterparty risk concerns.

In my opinion, too many activists, buy-side analysts, and sell-side analysts encourage and contribute to short-term thinking and poorly timed capital allocation decisions. I call them the Wall Street locusts. The Wall Street locusts are always on the lookout for a healthy balance sheet to devour and destroy before moving on to the next green pasture. I find this to be an interesting comparison to the pressures of holding cash in a portfolio when prices are high. Some investors want the portfolio manager to buy something with the cash, even though it may mean overpaying and result in future losses. Activists and analysts apply the same pressures to managements of cyclical companies. Acquire, buyback stock, or pay a dividend, but don’t just sit there with a strong balance sheet.

I disagree with the Wall Street locusts. In my opinion during booms, when free cash flow is high and capital is being accumulated, a highly cyclical company would be better served by retaining capital and liquidity. I believe capital would be better utilized during the bust to maintain adequate investment and spending. Furthermore, a strong balance sheet enables cyclical companies to not only survive, but thrive during recessions. A company with available capital is better able to acquire attractively priced competitors that may be distressed from overextending themselves during the boom. Assuming sufficient capital and liquidity, I also believe buybacks are reasonable uses of capital at troughs of cycles (when prices are most attractive). Imagine being an energy company currently with a debt free balance sheet and a large cash balance. Unfortunately, most of the energy industry is frozen and distressed because they leveraged up during the boom instead of preparing for the opportunity of the bust.

In my opinion, some activists, buy-side analysts, and sell-side analysts are not looking out for the best interest of public companies as their intentions are often short-sighted. In effect, they want a quick return on their investment and don’t plan to be around during the next bust. The activists usually want major change to the business structure that investors will view favorably, resulting in a higher stock price. Structural changes are often accompanied by major changes to the balance sheet. The buy-side is typically less aggressive than activists, but still encourage buybacks and dividends, even near cyclical peaks (after they’ve become shareholders). The sell-side likes acquisitions as they often come with debt and investment banking fees.

Instead of caving into pressure from Wall Street, I believe cyclical companies should think long-term (over an industry cycle) and fight demands from short-term investors whose recommendations are self-serving and are harmful to the balance sheet. A weak balance sheet not only increases the risk of bankruptcy during the next recession, it also reduces operational flexibility, detracts from investment, and may place the firm at a competitive disadvantage. In effect, companies that need liquidity to survive and prosper though an industry cycle need to prepare their balance sheets during the boom so they won’t be at an operational and financial disadvantage during the bust.

In fiscal 2013 and 2014 Kennametal bought back $135 million in stock. During that period its stock traded near $40 on average, significantly above today’s price of $27 and its recent low of $15. Kennametal also paid $165 million in dividends in fiscal 2013-2015. Kennametal has $700 million in debt ($540 million net debt) and $150 million in pension liabilities. Total equity is $1.17 billion, but a large portion of this ($514 million) is goodwill and intangible assets. If Kennametal didn’t make the large acquisition ($607 million) during the peak of its cycle, along with buying back stock and paying a generous dividend, they’d have a debt free balance sheet and excess cash right now. A debt free balance sheet would put them in an extremely advantageous position during today’s difficult operating environment. They could either acquire or buyback stock at much more attractive prices. Instead, they’ll need their free cash flow ($100 million 2017E) to continue to pay for past capital allocation decisions.

In conclusion, cyclicals can be great investments, but understand and manage the risks. Don’t extrapolate booms or busts and avoid leveraged balance sheets. And if you’re a cyclical business, don’t give in to the Wall Street locusts. Avoid the swarm and protect your balance sheet. You’ll be in a much better position to not only survive, but act opportunistically during your industry’s next inevitable bust.

Bottom-up Stable, Government Data Volatile

I didn’t read the employment report too closely, but did see the headlines. I continue to believe the best economic data comes from businesses, not the government. I believe Q2 2016 earnings and outlooks suggest not much has changed with the economy. At best things are mixed. I see very few pockets of aggressive hiring that would confirm today’s strong jobs data. That said, I am also not seeing aggressive layoff announcements. There have been restructurings in more cyclical businesses, but relatively I don’t think this has changed much over the past few quarters. So I’m not bearish or bullish on jobs, just seems like more of the same.

While the economy appears to be growing very slowly with some industries in recession, from a bottom-up perspective, things seem relatively stable in the real world. Meanwhile, government data is painting a volatile economic picture. Some reports such as employment suggest a strong economy, while other reports like durable goods orders show a severe recession. Deciding which report is accurate seems practically impossible given all of the adjustments and eventual revisions. Meanwhile the government’s economic reports move financial markets by hundreds of billions of dollars – it amazes me. In effect, I don’t see how value can be created by making investment decisions based on volatile and questionable government data, especially when bottom-up data isn’t supportive.

From a bottom-up perspective, Q1 2016 and Q2 2016 appear to be very similar quarters (feels like 1-2% nominal GDP growth). Based on management commentary and outlooks, in my opinion, it looks like Q3 isn’t expected to change meaningfully either. I suppose another round of asset inflation (new highs on stocks) could give the consumer a lift and pull more demand forward. However, based on consumer earnings reports this quarter, the Fed’s asset inflation policies appear to be only benefiting a narrow range of consumer companies. In previous posts we discussed PNRA, WOOF, and TPX’s ability to increase sales and earnings by raising prices (their customers’ are more willing to pay higher prices as they’ve benefited from asset inflation policies).

On another topic, the blog is now one month and 26 posts old! I want to thank all of you for visiting. I plan to keep going until I run out of things to say. In this environment that might be a long time! In addition to writing the blog, I’ve really enjoyed many of the email exchanges. Please feel free to contact me to ask questions or to simply talk markets and stocks. I’m also working on a mailing list (thanks for suggestions on this) and have a few things to work out before it can go live. For now, it’s safe to assume I’ll post most weekdays late evening. Also to contact me please use my gmail address as the contact option was not functioning properly so I took it down.

I’ve been pleasantly surprised by the number of readers and feedback. Apparently absolute return investing isn’t dead! Is it possible investors who simply want an adequate return on their money relative to risk assumed are the silent majority? Feel free to forward the site to other absolute return investors you know, or relative return investors you either want to reform or simply wish to push their buttons (it’s too easy).

Have a great weekend!

Non-Texas Non-GAAP Adjusted Results

The Texas economy is weak. This shouldn’t be a surprise given their exposure to the depressed energy industry. However, what is surprising is the number of companies blaming Texas for weak results this quarter. Interestingly, I don’t remember Texas being pulled out of operating results when its economy was booming (thank you Fed induced energy credit bubble).

One example of ex-Texas results came from Aaron’s (AAN) conference call last week, “In the quarter, same-store revenues were down 1.2%, and down 0.3% excluding Texas. This marks the fourth consecutive quarter of same-store revenue improvements. Texas had a pronounced negative impact on our comparable-store trends in the second half of 2015, and we are pleased to see improvement in both our Texas and non-Texas stores in the second quarter. Customer counts were down slightly on a same-store basis, and flat excluding Texas.”

I have nothing against Aaron’s. It’s a holding I’ve done well with and have owned numerous times (I do not own currently). And if management wants to disclose operating results for Texas, or every state for that matter, great – the more information the better. However, to be fair, I think it should be disclosed on both sides of the cycle.

Texas comparisons, along with energy related sales in general, will soon get easier for a lot of companies. For those companies pulling weak Texas and weak energy results aside this quarter, I hope this new information continues to be included once industry conditions improve and the energy drag becomes a benefit.

The Chicken and the Eggs

From Bill Gross today, “I don’t like bonds; I don’t like most stocks; I don’t like private equity.” Gundlach said practically the same thing last week and now Gross this week. Warren Buffett next week? I won’t hold my breath. In any event, my “Opportunity Set From Hell” post must have struck a chord with the bond kings! With all kidding aside, I couldn’t agree more with Gross and Gundlach and I’m invested accordingly. However, what I don’t understand is if Gross and Gundlach don’t like bonds, why are they still managing bond funds? Are the bonds they’re buying different? It’s the other bonds they don’t like? And if it’s all bonds they don’t like, why own any bonds?

Eight years of emergency monetary policies, ZIRP, and NIRP has certainly caused a lot of people, including professionals, to do some uncharacteristic things  – including buying bonds yielding next to nothing. Maybe Gross and Gundlach can pick fixed income securities that can generate a positive return even after the bond bubble pops. That would be impressive. However, if they say they don’t like bonds and then buy bonds to play the relative return game, that wouldn’t be so impressive.

I’d find it refreshing to see both of them stop playing the relative return game and join the absolute return team. Come on over – there’s plenty of room! If bonds are expensive, sell them. Take a stand against inflated asset prices, manipulated bond markets, and runaway train monetary policies. Maybe I just want a little company, but what I really want to see is a bond vigilante. I’ve read about them and would love to meet one. I continue to ask potential bond vigilantes, if not now, when?

Gross also mentions owning “real assets such as land, gold, and tangible plant and equipment at a discount”. I agree with this also. In fact, while I’m 100% cash in the absolute return strategy I manage (currently just my personal account), I also have exposure to tangible assets. However, I consider these outside of my managed assets, which remain very liquid and in cash (I own zero stocks personally). I believe if I’m going to hold cash in the current Wild West environment of central banking, holding some sort of cash hedge makes sense.

Although I can’t make specific recommendations, in my opinion, whatever a currency holder is most comfortable with and makes sense to them is a good place to start. I have a friend who owns commercial real estate and another that bought a McMansion on the water. Timberland may make sense for some. I used to own a timber REIT, Potlach (PCH) but they have a little too much debt for me now. Gold and silver are options. Farmland sounds interesting. I have a family member who bought recreational land as a cash hedge. Productive improvements to land and real estate (we did this) also makes sense to me. I have another friend who buys and fixes up old cars. Rental properties. There are plenty of options, but it’s up to the individual to decide if it’s necessary or what they’re most comfortable with and most knowledgeable about. Ideally cash holds its value and insurance isn’t necessary, but every time one of these central bankers talk, I can’t help but think their experiments aren’t going to land sunny side up.

I’ve joked with a friend that to hedge against global central bankers we should start a chicken farm. We’d profit handsomely assuming the world’s next reserve currency is the chicken and the egg! The chicken would be a $100 bill and eggs $20 (4 eggs), $10 (2 eggs), and $5 (1 egg). Go ahead and laugh, but you can’t print chickens and eggs. It might be messy paying the cable bill, however.

Economic Steak Indicator (ESI)

According to the USDA, meat consumption has increased 3% annually in developing and emerging economies since the mid-90s versus 0.4% in developed countries. The theory goes that with faster population and income growth, the demand for meat, or protein, expands. In effect, economic growth and demand for protein are correlated.

While I’m probably stretching this concept some, let’s also assume steak (protein) consumption and economic growth are correlated in the U.S. We’ll call it the Economic Steak Indicator (ESI). The ESI comes out every quarter after leading steak providers Ruth’s Hospitality Group (RUTH) and Texas Roadhouse (TXRH) announce earnings. The ESI measures the consumer’s willingness to spend discretionary income on an expensive steak. Combined, RUTH and TXRH cover broad regions and demographics. In case you missed it, the Economic Steak Indicator (ESI) was released today and it’s flashing pink red.

Ruth’s Hospitality Group (RUTH) actually announced earnings last week, not today. Their results and economic assessment were not as robust as past quarters. While comparable sales increased 2.3%, the gain was due to the average check increasing 2.9%. Traffic was weak and declined 0.5%. As we discussed in previous posts, I believe price increases are masking weakness in economic activity (traffic and volume) at several consumer companies this quarter. RUTH appears to be raising prices to offset higher costs. Management noted operating expenses were rising primarily due to higher labor costs which are being driven by minimum wage increases. Higher healthcare expenses were also mentioned.

Comments on labor were interesting and are similar to what several other companies have been discussing this quarter (productivity data supports as well). Management stated they were disappointed with the higher labor costs and lower revenue growth. Furthermore, they called the current economic environment “tough”.

In the Q&A session, management expanded on this by saying, “I think we’re seeing sort of a modest slowdown in all of our segments. I mean, so for instance, when we talk about private dining which is often a proxy for what’s going on with business travel, et cetera. It is still quite robust. It’s just not robust as it has been.” Management summed up their environment by stating, “Simply put, we faced slower revenue growth and higher year-over-year labor costs.”

Texas Roadhouse (TXRH) results were stronger relative to RUTH’s and the restaurant industry. However, relative to past results, TXRH showed a modest slowdown in growth. TXRH has been growing stores and comparable sales aggressively. It’s one of the few consistent growth stocks remaining in the restaurant industry. In 2015 it generated comparable restaurant sales growth of 7.2% at company restaurants and 6.5% at franchise restaurants. At 30x earnings TXRH is priced for growth.

Although growth slowed during the quarter, it was still above average with comparable sales growth of 4.5%. Looking ahead to next quarter, July comparable sales were slightly weaker, but still up approximately 3.7%. Management stated, “While this is a bit of a slowdown from early 2016, we are encouraged to see continued positive traffic growth along with solid comp sales trends on a two-and three-year basis.” Similar to RUTH, Texas Roadhouse pointed out rising labor costs, but noted food cost declined. Price increases were not up as much as RUTH with the average check increasing 1.6%.

In the Q&A session, management tried (without success) to come up with a specific reason for the slowdown in same-store growth. After an analyst inquired about slowing sales trends management responded, “I think as far as if you are looking at the most recent two-year trends, or even the most recent one-year numbers for us, 2% in June and 3.7% in July is definitely lower for us from what we have been experiencing. We don’t have the answer. We can only speculate. I can tell you, in our case, we are not operating any differently. We’ve got the same labor staffing, we’ve got the same food quality, we’ve got the same aggressive price points…”

“But I think anything about why as an industry or anybody specifically why sales might be tailing off I think is speculation. Everything from, is it related to there being a big shooting on TV every other day, it seems like, to the conventions, to the next thing we’ll be talking about the Olympics coming up in Rio.”

As management noted, they’re not doing anything different and aren’t sure why growth is slowing. Given similar reports from other consumer companies this quarter, I believe the slowdown in comps at TXRH is more likely tied to the economy than company-specific reasons. Although growth remains above average relative the industry, it appears investors were disappointed driving TXRH’s stock down 12% today. This is encouraging. I’d be interested in owning TXRH assuming growth investors continue to flee and drive its rich valuation down further.

In conclusion, the Economic Steak Indicator (ESI) is showing signs of a slowdown and confirms what several other restaurants and consumer discretionary companies are reporting. While the consumer isn’t in a recession, in my opinion, there does appear to be signs of hesitancy and softening in consumer spending. Auto sales are plateauing as well. With many industrial and cyclical companies in recession (energy is in a depression), where will the economic growth come from to support the good ol’ second half hockey stick recovery? Along with the ESI, the majority of the 300 companies I follow aren’t seeing it either.

Woof! Woof!

One of my favorite slides in a presentation I gave frequently was the historical batting average slide. It showed all my winners and losers since 1998, with winners and losers being defined in absolute returns. It was a simple slide. Did I make money on the stock or not?

As an absolute return investor it’s important to limit mistakes. What was unique about this slide is it had every one of my mistakes since 1998 listed on one page. I say unique, because I don’t know of another manager with such a long history who discloses all of his or her losers. Given it was almost two decades worth of history, I’m very proud of the limited number of losers. Even though the winners significantly outnumbered the losers, I always found it interesting that the audience usually wanted to talk about my losers. That was fine. I enjoyed talking about them as it helped me communicate the investment process and what I learned from each mistake. It also helped that they all fit in one column.

We all make mistakes in investing. Mine were all listed for everyone to see. It was nice to have it all out there. Or was it all out there? While all of my realized losses were disclosed, there were other mistakes that are more difficult to measure, but mistakes nonetheless. I’m talking about missed opportunities. In other words, after analyzing and valuing a business, I decided not to purchase a stock that proceeded to do very well. To be fair, I also had a lot of ideas I passed on that I’m very glad I didn’t buy (remember RadioShack?). However, considering the current bull market is now over seven years old, it’s not surprising I remember more missed opportunities than missed disasters.

In a bull market, it’s easy to beat yourself up over a list of stocks you should have bought. One of the nice things about investing and missed opportunities is you often get a second chance. I’ve found this especially true with certain industries such as commodities. Whenever an energy stock passes me by I just wait for their cycles to revert. I’ve found commodity stocks are either significantly overvalued or undervalued – they rarely seem fairly priced. It’s one area where investors love to extrapolate cyclical growth too far into the future. When cyclical stocks are priced as growth stocks, run for your life and avoid at all costs. Eventually commodity price cycles revert and the stocks come crashing down, providing patient investors with a second chance.

While missed opportunities often come back around and you get a second chance, sometimes they don’t. This is what happened to me after I worked on VCA Inc. (WOOF) approximately three years ago. VCA is a market leading operator of animal hospitals and veterinarian labs. It’s a good business with consistent and growing revenues and earnings. There are few services less discretionary than spending on your pet’s health.

I forgot the exact date I placed VCA on my possible buy list, but I remember liking the business. I also remember the stock was trading in the $20s. I don’t remember exactly why I decided not to buy at that time, but it may have been because of their acquisition strategy. I’ve discovered that companies that like to acquire often stumble from time to time, usually after biting off more than they can chew. It is when they suffer from acquisition indigestion and their stock plummets that I like to buy them.

I also like to follow a stock for a couple quarters after putting it on my possible buy list. I find it helpful to follow a company in real time. Furthermore, it allows me to make sure I didn’t miss anything, but most important it allows me to get to know management (compare words and actions) and the company better. This helps limit mistakes and improve the accuracy of my valuation, but at times it can also lead to a missed opportunity.

Unfortunately waiting to get know the business better or waiting for a more attractive price didn’t work with VCA. Their business has performed well since my initial analysis. Since 2013 they’ve grown revenues 18% and net income 54%. Over the past three years the stock has more than tripled to $71. I recently read their last earnings call and found a couple interesting observations. Although this earnings season has been mixed, VCA has bucked the trend and continues to generate above average organic growth of 5% to 6%. I believe VCA is a good example of consumers’ willingness to spend assuming they have the means and the need. Pets’ health qualifies as a need for many pet owners and is not considered a discretionary item by most who can afford it.

While other more discretionary consumer companies are reporting mixed quarters, VCA management is seeing strong fundamentals. Management noted, “The industry continues to do very, very well. Great demand, the economy is improving, a strong consumer. And I think we’re seeing great business based on pets with a lot of natural demand.”

Is organic growth coming from a strong economy or the fact that, as management states, people just love their pets? I agree VCA is benefiting from inelastic demand, but it appears higher prices and customers willing to pay them is helping as well.

An analyst asked the following question as it relates to pricing (hospital division): “Can you talk about pricing across the industry? I’m hearing two trends from industry consultants. Number one, that pricing has gone up a lot in the industry in the last couple years compared to where has in the past. But number two, prices could go a lot higher without any pushback.”

Management replied that although pricing was up “4 point something percent” it was probably closer to 2% given “the doctors are doing more medicine”. Management concluded by saying that rising consumer confidence allows for higher prices. “When they [consumers] think things are better, they are more apt to accept a price increase and then also more apt to work cases up and do more quality medicine, which translates to a higher price…But I think your assumption is that it’s — there’s more inelasticity to it is absolutely correct. There is. You do have a little bit more pricing flexibility than you did in the previous five years.”

This reminds me a lot of the Tempur Sealy earnings call we discussed last week, with pricing being a large portion of organic growth. I suspect Tempur Sealy and VCA have a similar customer base. I don’t know the last time you took your pet to a veterinarian, but the last time I did it set me back about as much as a new mattress!

I believe there is building evidence that a limited number of consumer companies that are generating above average organic growth are doing it at least partially, if not mostly, on price (not necessarily traffic or volume). And the higher the consumer’s income level, or exposure to asset inflation, the more likely the customer can afford the price increase and provide the wonderful earnings reports we saw with Tempur Sealy and VCA.

Interestingly, Tempur Sealy and VCA have almost identical stock price charts since the launch of QE3. Coincidence? I’m not so sure. Their stocks and businesses have most likely benefited from QE and the resulting multiple expansions and asset inflation.

Once this market cycle ends a lot of missed opportunities will revert to more reasonable valuations and there will be a lot more second chances. Whether VCA ever trades at an acceptable discount to valuation, I don’t know, but I’ll be waiting for it with open arms and abundant liquidity.

Parachute Pants

Did your parents ever tell you not to worry about what other people think? I remember my mother telling me this when I was in eighth grade. I’m not sure if she was simply giving good advice or trying to talk me out of buying parachute pants.

In the early 80’s parachute pants were a must have for the in crowd. I wanted to fit in, but my mom convinced me it wasn’t necessary to act and dress like everyone else. In hindsight, good call mom. Now if only she would have talked me into cutting off my glorious “Kentucky waterfall” mullet! The pressures of conforming and fitting in don’t go away after eighth grade – it sticks around many years thereafter. Investing is no different.

In the past I’ve discussed and written about the psychology of investing and the role of group-think. The pressure to conform in the investment management industry is tremendous, especially for relative return investors. As their name implies, these investors are measured relative to the crowd. One wrong step and they may look different.

Looking different in the investment management business can be the kiss of death, even if it’s on the upside. If a manager outperforms too much, he or she must have done something too risky or too unconventional. For some relative return investors being different (tracking error) is considered a greater risk than losing money. Losing client capital is fine as long as it’s slightly less than your peers and benchmarks. From what I’ve gathered over the years, to raise a lot of assets under management (AUM) in the investment management industry, the key is looking a little better, but not too much better, and definitely not a whole lot worse.

How did we get here? Since my start in the industry, relative return investing has gradually taken share from common sense investing strategies such as absolute return investing. How well one plays the relative return game is a major factor in determining how capital is allocated to asset managers. I believe this is partially due to the growing role of the institutional consultant and their desire to put managers in a box (don’t misbehave or surprise us) and turn the subjective process of investing into an objective science.

Institutional consultants allocate trillions of dollars and are hired by large clients, such as pension funds, to decide which managers to use for their plans. The consultants’ assets under management and their allocations are huge and have gotten larger over time, increasing the desire by asset managers to be selected. This has increased the influence consultants have on managers and how trillions of dollars are invested.

During my career I’ve presented hundreds of times to institutional consultants. While I have a very high stock selection batting average (winners vs. losers), my batting average as it relates to being hired by institutional consultants is probably the lowest in the industry. It isn’t that they don’t understand or like the strategy. In fact after my presentations I’ve had several consultants tell me they either owned the strategy personally or were considering it for purchase. Although they appreciated the process and discipline, they couldn’t hire me because I invested too differently and had too much flexibility and control (for example, no sector weight and cash constraints). In other words, they liked the strategy, but they were concerned that the portfolio’s unique positioning could cause large swings in relative performance and surprise their clients. In conclusion, in the relative return asset allocation world, conformity is preferred over different, as investing differently can carry too much business risk (risk to AUM).

Over the past 18 years the absolute return strategy I manage has generated attractive absolute returns with significantly less risk than the small cap market. Isn’t that what consultants say they want – higher returns with lower risks? Yes, this is what they want, but they want it without looking significantly different than their benchmark. This has never made sense to me. How can managers provide higher returns with less risk (alpha) by doing the same thing as everyone else? Maybe others can, but I cannot. For me, the only way to generate attractive absolute returns over a market cycle is to invest differently.

Investing differently and being a contrarian is easy in theory. When the herd is overpaying for popular stocks avoid them (technology 1999-2000). Conversely, when investors are aggressively selling undervalued stocks buy them (miners 2014-2015). It’s not that complicated, but in the investment management industry, common sense investment philosophies like buy low sell high have been losing share to investment philosophies and processes that increase the chances of getting hired. Instead of asking if an investment will provide adequate absolute returns, a relative return manager may ask, “What would the consultant think or want me to do?” I believe the desire to appease consultants and win their large allocations has been an underappreciated reason for the growth in closet indexing, conformity, and group-think.

In my opinion, the business risk associated with looking different has reduced the number of absolute return managers and contrarians. And some of the remaining contrarians don’t look so contrarian. For example, look at the four-star Fidelity Contra Fund. According to Fidelity this “contra” fund invests in securities of companies whose value FMR believes is not fully recognized by the public. Three of its top five holdings are Facebook, Amazon, and Google. I suggest the fund be renamed to the “What’s Working Fund”. With $105 billion in assets under management, one thing that is working is the sales department! Wow, that’s impressive. What would AUM be if the fund actually invested in a contrarian manner? My guess is it would be a lot lower, especially at this stage of the market cycle when owning the most popular stocks is very rewarding for performance and AUM.

I’m not just picking on Fidelity. The relative return gang is in this together. After the last cycle we learned most active funds underperformed on the downside. Given the valuations of some of the buy-side favorites currently, I suspect they’ll have difficulty protecting capital again this cycle once it undoubtedly concludes. This could be the nail in the coffin for active management. If the industry is unwilling to invest differently and they don’t protect capital on the downside, why not invest passively and pay a lower fee?

In my opinion, given the broadness of this cycle’s overvaluation, the most obvious and most difficult contrarian position today is not taking a position, or holding cash. In an environment with consistently rising stock prices and the business risk associated with holding cash, I don’t believe many managers are willing to be patient. That’s unfortunate because I’ve found the asset that is often the most difficult to own is often the right one to own. The most recent example of this is the precious metal miners.

After the precious metal miners crashed in 2013, I became interested in the sector and began building a position. Besides a couple positions I purchased during the crash of 2008-2009, I had never owned precious metal miners before. They were usually too expensive as they sold well above replacement value (how I value commodity companies). Miners are a good example of how quickly overvalued can turn into undervalued. In addition to selling at discounts to replacement cost, I focused on miners with better balance sheets to ensure they’d survive the trough of the cycle.

After the miners crashed in 2013, they eventually crashed again in 2014 and became even more attractively priced. I held firm and in some cases bought more in attempt to maintain the position sizes. After adding to the positions in 2014, they crashed again in 2015 and early 2016. I again bought to maintain position sizes. I’ve never seen a group of stocks so hated. Many were down 90% from their highs – similar to declines seen in stocks during the Great Depression. The media hated the miners with article after article bashing them and calling their end product “barbaric”. I haven’t seen many of those articles recently. The bear market in the miners ended in January. Today they’re the best performing sector in 2016, as many have doubled and tripled off their lows.

Owning the miners is a good example of how difficult it can be to be a contrarian. While clearly undervalued based on the replacement cost of their assets, there didn’t appear to be many value managers taking advantage of these opportunities. I thought, “Isn’t investing in the miners now the definition of value investing? Where did everyone go?” It was extremely lonely. Some investors argued they weren’t good businesses as they were capital intensive and never generated free cash flow. Obviously they’re volatile businesses, but after doing the analysis I discovered that good mines can generate considerable free cash flow over a cycle. Pan American Silver (PAAS) did just that during the cycle before the bust. As a result of past free cash flow generation, Pan American entered the mining recession with an outstanding balance sheet. New Gold (NGD) is another miner with a tremendous asset in its low-cost New Afton mine, which also generates considerable free cash flow. I also owned Alamos Gold (AGI). Alamos had a new billion dollar mine, Young Davidson, which was paid for free and clear net of cash and was expected to generate free cash flow. Alamos was an extraordinary value near its lows and was the strategy’s largest position in 2016.

Assuming a mining company had developed mines in production, generated cash, and had a strong balance sheet, I believed while the trough would be painful, these companies would survive and prosper once the cycle turned. They weren’t all bad businesses when viewed over a cycle, as all cyclical businesses should be viewed. Furthermore, many had very attractive assets that would take years if not decades to replicate.

In the end, survive and thrive is exactly what happened for many of the miners this year. I sold several as they appreciated and eventually traded above my calculated valuations. The remainder were liquidated when capital was returned to clients.  It was a heck of a ride and was one of the most grueling and difficult positions I’ve ever taken. But it was worth it.

The reason I bring up the miners is not to boast, but to illustrate how difficult it is to buy and maintain a contrarian position in today’s relative return world. I believe it helps in understanding why so few practice contrarian investing, or for that matter, disciplined value and absolute return investing.

During the two and a half years of pain (late 2013-early 2016), equity performance in the strategy I manage suffered. I initially incurred losses and was getting a lot of questions — I had to defend the position. Relative performance between 2012-2014 was poor (high cash levels also contributed to this). During this time, the strategy lost considerable assets under management. People were beginning to believe I lost my marbles. Whether or not I was going crazy is still up for debate, but one thing was certain, holding a large position in out-of-favor miners wasn’t encouraging flows into the strategy. While the miners were eventually good investments, in my opinion, they were not good for business.

As value investors we often talk about being fearful when others are greedy and greedy when others are fearful. However, in practice it’s extraordinarily difficult. In addition to the pain one must endure personally from investing differently, a portfolio manager also takes considerable career and business risk. Given how the investment and consultant industry picks and rewards managers, it can be easier and more profitable to label yourself as a contrarian or value investor, but avoid investing like a contrarian or value investor. Instead simply own stocks that are working and are large weights in benchmarks – the feel good stocks. I’ve always said I know exactly what stocks to buy to immediately improve near-term performance. Playing along is easy. Investing differently is not.

Investing to fit in with the crowd may feel good and it may be good for business in the near-term, but fads are cyclical and often end in embarrassment (google parachute pants and click on images). Participants in fads and manias often walk away asking “What was I thinking?”. But for now owning what’s working is working, so let the good times roll. I’ll stick with a more difficult position. Just like I did with the miners, until it pays off, I plan to stay committed to my new most painful contrarian position – 100% patience.

GDP and Gundlach

Given yesterday’s long post, we’ll wrap up the week with a short one. Two interesting topics I wanted to touch on today. First was this morning’s GDP report. According to the Commerce Department, GDP grew 1.2%, or half of what was expected. In effect, the U.S. economy lost at the earnings estimate game. Did its stock get destroyed? Not at all. The dollar was down slightly against the euro, but nothing spectacular. The yen’s movement didn’t count as it was distorted by the Bank of Japan’s “less than expected” decision on stimulus. The S&P 500 yawned at the weak GDP data and actually closed up.

Normally I don’t pay a lot of attention to macro data like GDP. As readers know, I prefer building a picture of the economy from the bottom-up. While GDP came in well below estimates, this shouldn’t be surprising for those of us (or readers of this blog) that have been monitoring the economy through actual business results. As I’ve attempted to illustrate over this earnings season, economic activity is not robust, with earnings in decline and revenues stagnant. Even the stronger reports haven’t been that impressive from a revenue and volume perspective.

If the Fed is data dependent, it’s not going to get much help from this number, even if there were bright spots. While the report showed household consumption grew an impressive 4.2% during the quarter, I’m skeptical. It doesn’t agree with what I’m seeing with the consumer companies I follow. I suspect this number will be revised down or was simply a rebound from a weak Q1 when household consumption was only 1.6% (seasonal adjustments may have influenced Q1 and Q2). Averaging Q1 and Q2 GDP would suggest a 1% growth rate, which is similar to what I’m seeing from businesses’ (organic revenue growth), so for what it’s worth, on total GDP I’m in agreement with the Commerce Department.

The last time the Fed had “data dependent” cover to raise rates was Q2 and Q3 of 2014. I remember those quarters were strong as I documented it in my quarterly letters. I was open-minded to the possibility the profit cycle was catching a second wind. In hindsight, those strong quarters were most likely due to a very cold winter or a seasonal rebound. Nonetheless, the Fed could have raised rates then, at least off emergency levels. Given what I’m seeing this earnings season, I don’t see how the Fed can raise rates in the near future. I don’t think rates should be where they are, but given the Fed’s data dependent stance, organic growth is simply not there for most companies or the economy. Today’s GDP report confirmed.

The second topic I wanted to discuss was an article a friend sent me today. The article was from Bloomberg, but the source was Reuters. In the article there was a quote from Jeffery Gundlach that supports my rational for going to 100% cash and recommending returning capital to clients. Mr. Gundlach said, “The artist Christopher Wool has a word painting, ‘Sell the house, sell the car, sell the kids.’ That’s exactly how I feel – sell everything. Nothing here looks good”.

Nothing here looks good — I love this quote and obviously couldn’t agree more. For what it’s worth, I actually did sell the house during the housing bubble. And during the current bubble, I actually did sell the car (I swapped into a much more dependable and affordable Toyota). I’m not selling the kids, but since I’m now unemployed, maybe I’ll sell their 529 plans. Just kidding kids!

Mr. Gundlach’s comments sound very familiar. The blog is going well. Is it possible the new Bond King is a reader? It must be frustrating being a bond manager in today’s environment. While I’m not holding my breath waiting for Mr. Gundlach to return over $100 billion in capital to his clients, it’s refreshing to hear another manager speak out against today’s “Opportunity Set From Hell” (see post below). I wonder how many other managers feel the same way. I suspect there is a lot of them, but unfortunately I don’t expect other managers to be as open about their beliefs. Bashing the asset class you’re attempting to sell can be bad for business.

Opportunity Set From Hell