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

 

 

 

McStagflation

After reviewing numerous quarterly reports and conference calls, it’s becoming clearer to me that the industrial economy remains in a recession. Consumer businesses are doing better relatively, but in my opinion, their results are not as strong as some of earnings game “winners” suggest. Today I reviewed the quarterly results of four consumer companies – two earnings game winners and two losers. The two earnings game winners were moderate to higher-end consumer companies that are more likely to benefit from record high stock prices. While the two losers have a consumer base with limited exposure to asset inflation.

One of the losers is a restaurant everyone knows and most likely has reviewed, McDonald’s. Normally I don’t spend a lot of time on large cap stocks, but their earnings release caught my attention. They lost the earnings estimate game by reporting $1.25 per share vs. expectations of $1.39 per share. In my opinion, the more important operating measurement was U.S. comparable sales, which only increased 1.8%. Management blamed lower than expected sales results on softening industry trends. But what really caught my attention was discussed on the conference call. Management noted, “In the US, second-quarter pricing year over year was up about 3%, compared with food away from home inflation of 2.6%.” With pricing up 3% and comps 1.8%, one can infer that traffic trends were negative.

McDonald’s customers are not exactly “loving it” in today’s economic environment. McDonald’s operating results are a good example of what happens when price increases meet stagnant wages. It’s also a good example of the disconnect between what I read on conference regarding price increases, or inflation, and what we’re constantly told by the Federal Reserve – that inflation is too low. I’m not seeing it Janet. McDonald’s quarter does not shout deflation, but instead it’s what I’d expect to see during periods of stagflation.

Management touched on industry conditions and the economy after an analyst commented on the “huge deceleration” within the restaurant industry. On the industry slowdown management said, “…well clearly — it’s been fairly well documented on the consumer slowdown across most consumer segments, to be honest with you, through this second quarter.” On the economy management noted, “I think generally there’s just a broader level of uncertainty in consumers’ minds at the moment, both trying to gauge their financial security going forward, whether through elections or through global events. People are certainly mindful of an unsettled world. And when people are uncertain, when families are uncertain, caution starts to prevail and they start to hold back on spend.” Pretty generic comments, but I thought it was noteworthy nonetheless. I’m a little skeptical of the election uncertainty excuse. It’s been used frequently this quarter. Does Trump or Clinton really impact your decision to order a Big Mac?

After reading McDonald’s conference call I wanted to read some good news, so I picked up Panera’s quarterly earnings report. Scrolling through the headlines I noticed Jim Cramer called it a blowout quarter, so I enthusiastically began to learn more. Panera won the earnings game by reporting $1.78 vs. its $1.75 estimate. The same-store comps I read in the headlines were an impressive +4.2%. However, after reading further, I discovered those comps were for company-owned stores alone. Franchise-operated same-store comps only increased 0.6%. Combined, system-wide same-store comps were up +2.3%, far from the blowout quarter Mr. Cramer claimed. And here’s the kicker when it comes to the company-owned comps of +4.2%. The growth came from transaction growth of only 0.4%, while average check growth was 3.8%. While slightly positive (a little better than MCD), traffic growth was weak as most of the comp growth came from price increases.

If inflation associated with dining out is running between 3-4%, it’s not surprising traffic growth is struggling at McDonald’s and Panera. Is the restaurant industry’s weak traffic trends in Q2 inflation related? After eating out for lunch and dinner today (I’m on the road again) and paying through the nose for mediocre fare, I think it’s highly likely! In fact after dinner tonight, I stopped by the grocery store and bought a less expensive and healthier option for lunch tomorrow.

Rent-A-Center was another consumer stock loser, as it missed earnings estimates considerably. Earnings per share were $0.19 vs. $0.43 and sales declined -8.1%. Same store comps were -4.9%. No way to spin this one pretty and management didn’t try. Poor results were attributed to issues with its point of sales system, weakness in oil markets (Texas 10% of sales), the reset of its smart phone category, and declining computer and tablet sales. Management was extremely disappointed. Investors were as well, driving its stock down 18%. In my opinion, Rent-A-Center’s customer base remains under stress and I’m not expecting an immediate turnaround.

For companies with aggressive buyback programs and above average dividends, please take note. Rent-A-Center bought back $200 million of stock in 2013 at much higher prices. Also, between 2013 and 2015 it paid out approximately $150 million in dividends. During this period it took on debt to help fund these shareholder friendly initiatives. It’s always tempting to reward shareholders when times are good, but sometimes it’s better to shore up the balance sheet for a rainy day. That day is now for Rent-A-Center. With $636 million in net debt, I’m sure they’d like to have some of that cash back.

Lastly, we’ll end with an earnings game winner, Tempur Sealy International, Inc. (TPX). Tempur Sealy squashed earnings estimates as it reported $0.92 vs. the $0.68 estimate. However, GAAP EPS was less impressive at $0.35 vs. $0.34. To understand the difference between the adjusted non-GAAP and GAAP earnings all one needs to do is comb through the 18 footnotes at the end of their earnings report. I did. One thing that stood out was $4.2 million in annual meeting costs in 2015. Nice. I’d like to have attended that one!

Temper Sealy adjusted non-GAAP earnings benefited significantly from higher adjusted gross margins of 40%. Margins improved due to operational improvements, pricing and mix. There’s that “pricing” comment again. If we’re having all of this deflation, why are there so many comments related to higher pricing on conference calls? By the way, Astec Industries, which we discussed yesterday, noted on their call that they are watching rising steel prices closely (more price increases). In any event, back to Temper Sealy. How much of their growth was pricing and mix? While sales were up 5.2%, management noted units sold only increased +2%.

Despite the slow unit growth, investors apparently loved the quarter and drove Tempur Sealy’s stock up 17%. I would have expected stronger organic growth given the stock’s large jump. Even Tempur’s management tempered (sorry) their enthusiasm by providing low single-digit sales growth guidance for the year. Management noted the worldwide economy is doing “just o.k.” and they pointed to some headwinds such as the election, international events, and currency. Management described the economy as having a 1.5% to 2% GDP feel. However, their best description of the economy was, “feels good, feels weak, feels good, feels weak”. That’s more accurate and clear than most economists!

In conclusion, a mixed earnings picture from four consumer companies. I found comments on pricing, traffic, and unit sales very interesting. The moral of the story is you can raise prices if your customers are benefiting from asset inflation and can afford to pay a 40% gross margin on a $5,000 mattress. However, if your customers’ spending decisions are largely dependent on fixed wages, raising prices may backfire and turn customer traffic or units sold negative.

Lastly, given the sharp rise in stock prices, I was surprised by the actual top line results of the companies that won the earnings estimate game. In my opinion, revenue growth did not appear overwhelming, especially after pulling out the effect of price increases. So goes the earnings estimate game, where actual results and real data points take a back seat to the “achievement” of jumping over spoon-fed earnings estimates.

New Roads and Bridges Beat New Countertops

I’ve been doing a lot of driving over the past couple of weeks. Two things I’m certain of: 1) there is a lot of road construction; and 2) I’m not going long corn as this year’s crop looks very healthy! The first point (a lot of road construction) is good news for Astec Industries, Inc. (ASTE), a market leading manufacturer of road building equipment. Founded in 1972, Astec’s products are used in each phase of road building.

While earnings season so far has been mixed to soft, Astec’s quarter stood out and showed strong growth. Sales increased 10% and EPS increased 55% to $0.79. Backlog improved considerably as well, up 59% to $365 million. Astec is benefiting from the passage of the 5-year $305 billion Federal Highway Bill that was signed by President Obama in December 2015. The passage of the highway bill provides some certainty for Astec’s customers and should benefit Astec’s operating results over the next few years.

The last time Astec’s customers had this type of visibility was after President Bush signed the Safe Accountable, Flexible and Efficient Transportation Equity Act in 2005, which authorized $286.5 billion in funding for federal highway and transit programs through September 30, 2009. Astec’s business performed well during this period as earnings per share (EPS) grew from $1.34 in 2005 to $2.80 in 2008. The program ended in 2009 and was replaced by month to month appropriations. Astec’s business suffered considerably once government funding certainty was replaced with uncertainty – EPS fell to $0.14 in 2009. Astec’s stock collapsed from its high of $57 in 2007 to $22 at its low in 2009.

In the current earnings environment of slow to negative growth, investors are willing to pay a very high price for above average growth and certainty. As investors stampede into anything with growth, Astec’s stock has benefited and is up 58% to $61 (all-time high) over the past year. The sharp increase in its stock price has driven Astec’s P/E ratio to 40x. At such an expensive valuation, investors are most likely valuing Astec based on its future earnings estimates. As earnings continue to increase, EPS could reach mid $2’s later this year and low $3’s later next year. I believe these earnings expectations are reasonable and are not too different from its last earnings cycle peak of $2.80/share.

In addition to being an example of investors’ eagerness to pay a high price for growth and certainty, I believe Astec is a good example of the growing use of peak earnings to value businesses. In Astec’s case, investors are valuing the business not only on peak earnings, but on peak earnings that have yet to occur (an even more aggressive valuation technique).

Although I believe Astec will generate healthy earnings growth over the next two years, a lot of this growth is cyclical, or growth coming off depressed earnings. In my opinion, given Astec’s valuation, investors are valuing the business as if recent growth is sustainable, not cyclical. The fact of the matter is Astec is a cyclical business. There’s nothing wrong with this, but extrapolating cyclical growth and valuing it as sustainable growth is another one of my top ten investment commandments – Thou Shalt Not Extrapolate Cyclical Earnings Growth.

Uncertainty and volatility in government funding is one of the reasons Astec’s business is cyclical. A large portion of Astec’s business is tied to government spending and is reliant on politicians coming to an agreement. Although funding can become tight during economic downturns, I believe during the next recession politicians will agree on providing fiscal stimulus. Furthermore, to fund the stimulus, I believe both parties will prefer the voter-friendly option of printing money, versus the more difficult decision of raising taxes or cutting spending. Therefore, I wouldn’t be surprised if helicopter monetary policy comes to the U.S. during the next recession – directly funding aggressive fiscal spending with monetary policy/money printing.

Unlike Japan, which may simply print money and hand out checks, I believe if helicopter drops come to the U.S. the majority of it will be project-based, such as spending on public projects such as improving roads and bridges. While I don’t agree with policy solutions that rely on getting something for nothing (money printing), I suppose a government induced bubble in infrastructure is better than what we received during the last cycle of malinvestment. After the housing/mortgage bubble popped, we weren’t left with much except for trillions of bad debt and millions of new granite countertops!

If helicopter drops are used for infrastructure and investment I suspect companies like Astec will benefit. Unfortunately, in my opinion, potential benefits have been priced in Astec’s shares, especially if using normalized earnings for valuation purposes, not future peak earnings.

Pizza! Pizza!

I rarely watch CNBC. That wasn’t always the case. I watched it in the early 90s when Neil Cavuto was the network’s rising star. He was very good and had some interesting guests. Things have changed a lot since then. Of course Neil is no longer with CNBC and the guests are, well, let’s just say a lot of them are a little too promotional for me. When I do watch CNBC it’s usually in a common area, like a gym. Today was one of those days as I watched from a treadmill.

The segment I was watching started by saying stocks were trading at 25x earnings. I thought, “Wow, they must be using GAAP earnings, not adjusted non-GAAP.” And they were, which immediately got my attention and increased my respect for the host and the network (even better if they used GAAP cyclically adjusted P/E, but I’ll take what I can get). Had something changed while I was away? Unfortunately nothing has changed. It was just a teaser before the good stuff began.

The host went on to say while stocks look expensive based on GAAP earnings, if you look at it from projected (non-GAAP) earnings, stocks are “only” trading at 17x earnings. The host then opined that above average valuations may be irrelevant given low bond yields. This was the setup before turning to the guest. As 9 out of 10 portfolio managers that appear on CNBC do (I have no data supporting this), the guest began to tell investors that there is no alternative (T.I.N.A.) to stocks. I immediately grabbed the remote and searched frantically for Bloomberg TV, which isn’t much better, but I like their scrolling headlines.

Is this the best the investment management industry has to offer? There is no alternative? And I thought “The New Economy” rational in 1999 was looney. Will T.I.N.A. be in the new fiduciary duty rules? Always act as a fiduciary…unless of course there’s no alternative, then do whatever you want with other peoples’ money. In my opinion, T.I.N.A. is just one more excuse, or easy to understand one-liner, to help sell and justify overpaying near the peak of a cycle. There may not be an alternative for central banks (to keep the game going) and relative return investors (to keep playing the game), but absolute return investors have a choice.

The logic behind T.I.N.A. goes like this. Because rates are so low and are expected to stay low indefinitely (so they say), it’s acceptable to alter valuation variables to make stocks appear more attractive. A high quality stock is essentially a perpetual bond with a variable coupon. How you value a perpetual bond is simple. It’s cash flow divided by discount rate (CF/k). Forgive me if this is review for many of you, but we have a few readers who majored in psychology (they probably tend to be better investors than finance majors).

Let’s assume you have $100 in annual cash flow and you demand 10% return on investment. Let’s also assume the cash flow is stable indefinitely. In this case, the value of this perpetual stream of cash flow is $1,000. With interest rates so low, the theory is an investor should reduce the discount rate, or required rate of return. If the investor lowers the required rate of return to 5% from 10%, the value of the same stream of cash flow jumps to from $1,000 to $2,000. This is what has happened to stocks this cycle. We’ve had huge multiple expansion, which is another way of saying investors are requiring less return to assume the same risk. They are doing this because apparently “they have no alternative”.

Here’s the problem with lowering investment standards, and in this case, lowering the required rate of return assumption. When valuing risk assets, the discount rate is used to measure risk or the uncertainty of an investment’s future cash flow. As I illustrated in previous posts, risks to company cash flows are alive and well. After Q2 we’ll have had five consecutive quarters of negative earnings growth. If risks to cash flows haven’t been reduced, why should an investor demand a lower return on investment? Businesses are not risk-free and shouldn’t be valued as such. Furthermore, I don’t believe artificially suppressed risk-free rates should be the starting point or foundation of a business valuation.

To think about this in simple terms, pretend you own a pizza shop (during asset bubbles I often imagine making pizzas instead of fighting the Fed). You buy the pizza shop for $200,000 and it generates $50,000 a year in cash flow. So you’re receiving a 25% return on your investment assuming cash flows remain stable. But stable cash flows is a dangerous assumption when running a business and that’s why you’re requiring a much higher return on capital than a risk-free rate (also known as a risk premium). Do you care about risk-free interest rates? Maybe if you borrowed to buy the pizza shop or if your lease is tied to interest rates in some way, but for the most part you’re much more concerned about operating risks.

Cheese prices are volatile and a major cost. Minimum wage is increasing. Oh no, the health inspector just shut you down for a week. Papa John’s and Little Caesars are both opening next door – pizza price wars! Pizza ovens burn a lot of natural gas. Your delivery guy just ran over a $5,000 poodle. Your building was just bought by a private equity firm that overpaid and they are raising your rent 20%. The kid running the cash register is missing and so is the cash. All of a sudden the positive $50,000 cash flow you were valuing is now negative -$50,000. Is your business still worth $200,000?

In effect, are risk-free rates relevant to your pizza shop valuation? I don’t think so. In my opinion, operating risks of a business are the most important risks to cash flows and it is the risk to cash flows that should determine an investor’s required rate of return, not risk-free rates. I prefer using a required rate of return that consists of what I’d lend to a business and then apply an equity risk premium on top of that (combined it’s typically 10-15% discount rate). Granted this valuation technique remains subjective, but it makes much more sense to me.

For those who continue to insist the risk-free rate should be the foundation of business valuation (academic version and often used by those with perfect SAT scores), the math still doesn’t work. If one were to use a low discount rate based on low risk-free rates, they must also assume risk-free rates stay depressed indefinitely. If we assume interest rates stay depressed indefinitely, shouldn’t we also assume growth rates remain depressed? Isn’t subpar growth in domestic and global economies the reason risk-free rates are low? You can’t have it both ways — if you use a lower required rate of return due to abnormally low risk-free rates, you can’t also assume normal growth rates. In theory, the lower growth rate would offset the valuation benefit from the lower discount rate (CF/k-g).

We’ll get back to actual businesses and operating results tomorrow, but I thought it was important to touch on why lowering valuation standards doesn’t make sense to me. I believe T.I.N.A. is just another end of the cycle excuse to overpay, or one more version of this time is different. When has lowering your standards ever worked in life? Why do it with your money, or even worse, someone else’s money. No more CNBC for me! However, a pizza sounds good.

What’s the Deal With Japan? (Seinfeld tone)

A friend of mine just emailed me a headline “BOJ Officials Said to Be Leaning More Toward Easing”. The helicopter money drops are coming — get out your fishing nets!

Here’s what I don’t understand about Japan. They’re scared to death of deflation, but it’s one of the most expensive places in the world to live. How does that make sense? In 2013, CNN Money ranked Tokyo and Osaka, Japan as the two most expensive cities in the world. Does Japan really need higher prices to prosper or are they looking for a free ride (fund unmanageable debt with unimaginable monetary policy)?

“If You Think Nobody Cares About You, Try Missing a Couple Payments”

The quote above is from one of my favorite comedians, Steven Wright. I’m not sure if he’s still performing, but he’s the dry humor guy with an extremely slow and unique delivery. He’s hilarious and his jokes are very clever. One of his jokes goes something like, “If you’re driving in space traveling at the speed of light and you turn your headlights on, does anything happen?” I remember this joke because when I first heard it instead of making me laugh, it made my head hurt! That’s exactly how I feel about financial markets these days and the global central bankers propping them up.

Over the weekend I thought some more about earnings season. Although it’s happened for several quarters now, I continue to be surprised stocks are holding up as well as they have. I’ll admit this market cycle has lasted longer than I expected. Given how expensive stocks have become, I believed once earnings began to decline, stocks that were priced for perfection would abruptly reverse once investors realized fundamentals were anything but perfect. After four consecutive quarters of earnings declines (soon to be five), that has not been the case.

While earnings season remains young, so far I’m not seeing sufficient evidence that would suggest a reinvigorated corporate earnings cycle. In fact according to FactSet, earnings for Q2 are expected to decline -5.5%. FactSet states, “If the index reports a decrease in earnings for the quarter, it will mark the first time the index has seen five consecutive quarters of year-over-year declines in earnings since Q3 2008 through Q3 2009.” The earnings cycle ended long ago, but the market cycle (second longest in history) marches on.

Why has there been such a large disconnect between fundamentals and valuations this cycle? We all know. It’s no secret global central banks have hijacked the financial markets with eight years of emergency monetary policies. Whether central banker policy is meant to create asset inflation, fund fiscal deficits, raise capital gains taxes, make 1-2x government debt to GDP affordable, or simply keep it together until the next policy maker comes into office, is all up for debate. What we do know is central banks have set interest rates and bond prices. This is undeniable. As a result, they have also interfered with the pricing mechanism of all asset prices. What asset class is not dependent on interest rates or their cost of capital? If the cost of capital of all asset classes is manipulated and untrue, isn’t information derived from asset prices misleading? I think so.

I have a love-hate relationship with the Federal Reserve and central banks. I despise their interventionist policies. I believe capitalism and free markets are wonderful concepts if allowed to function properly. Current monetary policies and the temporary suspension of free markets truly make me sad. Over the past twenty years I’ve witnessed some very serious monetary policy errors along with three Fed-induced asset bubbles. While I was also upset about monetary policies during the tech and housing bubbles, I acknowledge I benefited from these imprudent policies as the asset bubbles eventually popped, creating massive dislocations between price and value (opportunity). Given my current positioning, I again expect to benefit once the Fed’s third bubble in only 17 years pops.

While I’m looking forward to future opportunities, for now it’s steady as she goes for rising asset prices. According to a July 21 Bloomberg article, the S&P 500 enjoyed its fourth weekly gain last week. Although companies continue to beat their spoon-fed earnings estimates, I believe actual operating results have been insufficient to drive stock prices higher. In my opinion, stock prices continue their march higher because of relentless global central bank policy, not fundamentals.

The Bloomberg article points to the catalyst of the current rally, “Expectations for lower rates or additional bond buying had sparked a three-week rally in global equities that added more than $4.5 trillion in value.” So much for the negative impact of Brexit. Not only did the unexpected Brexit not harm investors, it provided them with a $4.5 trillion bonus for misjudging its likelihood! In effect, Brexit provided central bankers with cover to keep policies extremely easy. So now not only do we have the central banker “put” on risk assets, investors now also receive free call options! Simply amazing. I miss free markets and I miss investing.

I don’t know what to call allocating capital in these markets, but I’m reluctant to call it investing. That’s a shame given the extraordinary amount of human capital being consumed by the investment management industry. If central banks fix asset prices how is this investing? If this isn’t investing, what is it? And if we all know prices are fixed and artificial, why are so many playing along? Where are the bond vigilantes for goodness sake? If you’re not going to be a bond vigilante now, when?

Absolute return investors need not worry. They aren’t required to play the game. The best game to play now, in my opinion, is patience, discipline, and preparedness. When policies fail, free markets and investing will return, along with another round of wonderful opportunities. Until then, let ‘er rip Yellen, Draghi and Abe. The crazier heights policies and prices reach, the more opportunities in the future for those of us not playing along. A final quote from Steven Wright to sum up the current investment environment and market cycle, “The early bird gets the worm, but the second mouse gets the cheese.”

Examples Please

As an absolute return investor, it’s very important to limit mistakes. One mistake that can be made when valuing a business is taking overly optimistic management projections as fact. This goes beyond the second half story we touched on yesterday. Sales and profit margin goals can go out several years. As an analyst hungry for ideas, it can be tempting to plug aggressive assumptions in a valuation model in an attempt to manufacture investment opportunity.

In a corporate world addicted to the use of non-GAAP adjusted earnings and pro-forma earnings going out to 2017, 2018, and beyond, it’s becoming increasingly important to determine if projections are achievable. Making this task more difficult is the fact that there are a lot of good salespeople in corporate America, and on Wall Street for that matter. Many of these great salespeople make their way up to the top of the management structure and become CEOs. Charismatic CEOs are likable, great story tellers, and easy to believe.

How can absolute return investors combat this? Time is my favorite weapon. The longer a business has been in existence, the more actual results are available that can be compared to previous management predictions. Does management have a history of telling the truth and providing realistic guidance? This is one of the reasons why I like established companies, many of which have been around for several decades. Following businesses over many years also helps an investor properly read the person distributing the spin. Over time I’ve learned which CEOs tend to tread conservatively and which CEOs have won academy awards for their role in giving financial projections.

Some CEOs are just born this way. You can’t stop them. They can’t help it and they just love to sell. This is fine from a business perspective as it probably means they’re good at selling their products or services. However, from an investment perspective it’s the analyst’s job to be aware of the CEO’s powers and adjust their valuation variables accordingly.

Another defense against financial spin is asking for examples. I’ve found superheros of spin do not like giving detailed examples — it’s their kryptonite. It interrupts their script and it’s just not exciting theater. They might have one or two examples prepared, but if you keep digging, don’t be surprised if the charismatic CEO hands the question over to the boring CFO. For example, when a business has a 15% margin goal by 2020, ask specifically why they’re confident margins so far out into the future can be predicted accurately. And don’t take generalizations for an answer. The great spinners will go on and on without talking specifics. If they say synergies, ask for specifics. If they then say back office consolidation, ask for more specifics. Don’t be surprised if it ends there, but then you’ll have your answer. If detailed and quantifiable examples cannot be given, I believe it’s better to rely on proven operating metrics such as historical (over a cycle) profit margins and cash flows.

The above also applies to the asset management industry. For those of you that are fund shareholders and interview fund managers, I suggest doing the same. Grill your portfolio managers on their holdings and you’ll soon learn how involved the managers are in running the portfolio. Ask for specifics rather than accepting broad generalizations like “we’re focused on quality stocks” and “we’re defensively positioned”. Given how expensive quality is trading today,I’d have a field day with that one. In any event, as holding stocks and bonds become more and more difficult to justify, I suspect Wall Street’s spin levels will increase along with asset prices.

I didn’t intend to talk about corporate spin again today after touching on the second half recovery story yesterday. However, after reviewing today’s earnings reports, I found a couple good examples of what I was discussing yesterday. This reminded me of the importance of asking management for examples so I thought I’d discuss.

Yesterday I talked about the second half story and when it isn’t achievable management will often guide earnings lower. Shortly after, the company will then beat the lowered guidance and the stock will go up. I know this doesn’t sound logical, but it happens frequently in today’s warped markets. It happened today with Werner Enterprises (WERN). Werner is a trucking company with a nice balance sheet that I’d actually consider owning at the right price. On June 20 they reduced earnings guidance to $0.21 to $0.25 for the second quarter. Analysts at the time were expecting EPS to reach $0.40, so this was a big disappointment. Today Werner announced actual EPS of $0.25 which was at the high end of guidance and beat analysts’ lowered earnings estimate.

When Werner preannounced its poor results after the market closed on June 20, its stock was at $24.68 and fell to $22.31 the following day. Today its stock spiked higher on its “good” earnings report and ended the day at $25.26. So Werner’s stock was up today above where it was before they preannounced poor results. All of this because it won the “beat the earnings estimate” game even though the estimate they beat was lowered significantly a month ago. And to be clear, it wasn’t a good quarter. Results were poor due to soft freight demand (sales down -7% and earnings down -43%). The company acknowledges this in their earnings release, “Second quarter 2016 freight demand was significantly softer than freight demand in the second quarters of the prior two years.” Sounds like bad news doesn’t it? Not in this market — Werner’s stock increased 5% today.

Watsco (WSO), a leading distributor of HVAC equipment, also provided a good example of the second half story. Although Watsco actually lost the earnings estimate game along with reporting weak Q2 results (small declines in revenue and earnings), management offset this bad news by making positive comments about performance in July. Despite weak results, investors looked to the future (the second half) and drove Watsco’s stock up $2.

There were several more earnings reports Friday that I’d like to discuss, but I went on longer than normal today so I’ll stop here. Overall I thought earnings today were a little weaker than earlier this week; however, I thought investor responses have been much more positive than I’d expect given results. We have a long way to go in earnings season, but so far it’s been mixed at best.

Second Half Hockey Stick Dream

I just counted. I’ve been through 90 quarterly earnings seasons. What do half of these quarters have in common? The second half of the year will be stronger than the first half! I love this story — it never gets old. Tell it to me again. And again. And again. By now I know this story is usually fiction, but the sell-side analysts seem to play along year after year. I’m not sure why, but I have theories that range from analyst turnover to it’s easier to fill in an earnings model by simply cutting and pasting company guidance.

Very rarely does a company in the first half of the year say the second half will stink. They almost always say the future will be brighter. It encourages confidence and optimism – not to mention a higher stock price! What’s the downside? If management is wrong they’ll simply call their favorite sell side analysts and encourage them to gradually reduce their estimates. The company will then beat the “new and improved” lowered guidance and the stock will go up again. Do you see how this works? My favorite part comes after the company beats lowered guidance and the analyst who was played like a fiddle says on the call, “great quarter guys!” I’m sorry for making fun of the second half rebound story and everyone who plays along year after year, but it’s just too easy.

Given the popularity of the second half story, I was surprised by Graco’s (GGG) guidance today. Graco manufactures equipment that pumps and dispenses fluids. They have a very broad product line and have three divisions:  Industrial, Process, and Contractor. When I think of them I usually think of paint sprayers, but they manufacture a lot more. As a business, I like Graco and consider them a high quality cyclical company. As many companies I follow with industrial exposure are reporting, Graco experienced a slow top-line quarter (3% organic sales growth). Graco also lowered its expectations slightly for the year. Management stated, “Modest first half organic growth has resulted in a reduction in our full-year outlook for 2016. We have revised our low-to-mid single-digit growth expectation down to a new outlook of low single-digit growth.”

I shouldn’t have been surprised by Graco’s quarter or outlook as it coincides with what I’m seeing in the sectors where they’re seeing softness. What surprised me is they didn’t provide second half guidance showing a rebound. This was Graco’s response to a question regarding their industrial business and their second half outlook (minute 32 on today’s call). Management stated, “I don’t want to make it sound like today we’re giving up hope, but I want to be realistic. And we don’t want to sit here and tell you everything is going to be rosy in the second half.” “…and we don’t know what’s going to happen globally and the geopolitical environment in the second half so we definitely as a group we haven’t given up on the second half, but what we’re trying to do is communicate that from a realistic viewpoint we ought to think about the second half on industrial more like the first half than on some hockey stick that is based upon a dream. [emphasis mine]”

Thank you Graco for your honesty. They don’t know so they’re not going to predict a “rosy hockey stick second half”. Instead, management is going to use a “realistic viewpoint” that isn’t based “upon a dream”. How refreshing and good for Graco! Their business is naturally cyclical and it’s ok not to know, especially in a challenging operating environment. This goes back to my belief that equity risk premiums are too low and should not be abolished by another crowded “this time is different” theme. Risks to companies’ cash flows have not diminished. They are alive and well, no matter how many times we’re told the second half is going to be better.

 

You’re Fired! (May) You’re Hired! (June)

A couple weeks ago the Department of Labor reported 287,000 jobs were created in June. A robust report. However, a month prior, the Department of Labor reported only 11,000 jobs were created in May. A very weak report. Is the labor market weak or strong and why the huge dispersion between months? I believe it has more to do with the government’s calculation methodology than reality.

From what I observe with the businesses I follow, barring a sudden shift in demand for products or services, companies don’t significantly alter labor plans from month to month. Labor decisions aren’t made lightly as turnover and misjudging the need for labor can be very expensive. Before hiring or firing, companies want to be certain changes in demand trends are sustainable. For example, when demand plummeted in the second half of 2008, many companies I follow waited before announcing layoffs to make sure the decline in demand wasn’t just a blip. It took some companies a couple quarters to finally face the facts and bring costs, along with labor, in line with new demand.

I continue to find it amusing that investors pay so much attention to the monthly job reports. We know government estimates on jobs can be lumpy and we know they’ll be revised (often sharply). There are also seasonal adjustments and the birth death model (estimate of job creation from business startups) that significantly influence the government data. As I commented in a previous post, if you want a clear picture of what’s going on with the real economy, consider getting your data points from actual businesses, not the government.

Fortunately we received a timely economic and employment data point yesterday when Cintas Corp. (CTAS), a market leading uniform company, reported earnings and provided insightful commentary on its conference call. Approximately 50 minutes into the conference call an analyst asked a question regarding employment trends. Management’s response was very interesting and confirms what I’m seeing with many of the companies I follow – growth remains uneven and slow, but is also not getting significantly worse. It’s more of the same — a similar environment to what I’ve been documenting since mid-2014, when the economy and profit trends were considerably stronger.

The analyst initially asked management about the negative impact from the oil and gas industry. As I mentioned in a previous post, I believe the earnings drag from the energy industry will continue, but companies have had time to adjust and comparisons should become easier. Cintas confirmed this by saying, “Well, we — from an oil, gas and mining standpoint, we have seen continued deterioration, but I would say today, that rate of deterioration is slowing, certainly relative to 90 days ago.”

Management went on to discuss the economy more broadly, “…let’s call it [the] economic picture, I would say that it’s still a challenging environment. There’s not a lot of momentum to it. But I would call it stable. We haven’t seen a lot of change today compared to a quarter ago. And so, I would say we are continuing to operate like we have been.  I would say as we look into fiscal 2017, if I were to make a comment about the economy that maybe did feel a little bit different, I would say today compared to — let’s call it six months ago, it does feel like there is a bit more uncertainty [emphasis mine]…We’ve seen the European issues; we’ve seen changes from the Department of Labor in terms of minimum wage and overtime that can have a pausing effect on our customers. We’ve got the election coming up. It does feel like there is a little bit more uncertainty than there was six months ago.”

So there you have it from the uniform maker’s mouth. Makes sense. I suspect May and June employment reports are inaccurate and the truth is probably closer to the average of the two months. Management’s comments were also helpful in confirming my macro views. Cintas sells to 900,000 businesses. I believe that makes them qualified to talk about the economy and employment trends. I’d much rather hear Cintas’ opinions on the economy and employment than those of a highly paid economist analyzing stale government data.

It’s very early in small cap earnings season, but so far it looks as expected and similar to what we covered in a previous post. Most companies are easily beating estimates, but overall organic top line growth remains challenging. This earnings season I’ll continue to point out data points I find interesting and any new developments that may appear. While fundamentals and valuations are currently not the main drivers of asset prices, I continue to believe it’s important to stay informed from a bottom-up perspective.