Normalizing Earnings and Real Rates

I just completed a post discussing the pros and cons of the Shiller PE. After reading it I thought, “Geez, as much as I like discussing cyclically adjusted earnings, this is a boring read.” While some of you would like it, I think it would put too many readers to sleep. Therefore, I decided a more interesting way to discuss the topic was to publish an email exchange I had with a friend and fellow absolute return investor.

Discussion of the Shiller PE with fellow absolute return investor…

Me: Many articles and studies on stock market valuation state today’s market is the most expensive in history, except for the 2000 peak. After looking at the long-term Shiller PE chart this appears true. However, is it an apples to apples comparison? Specifically, during 1991-2000, central banks were not artificially suppressing real interest rates through asset purchases. What do you think about calculating a Shiller PE using a historical average real rate of around 300 bps, or similar to what we experienced in 1991-2000? In effect, making the periods more comparable.

Absolute Return Investor: To be clear, your point is if real interest rates were near average, borrowing costs would eat into EPS, hence a higher Shiller PE? If so, I’m in favor of any ratio that shows valuations more on an operating basis. I’m curious to know how you would calculate. Just take interest expense/debt for every company and add 200 bps?

Me: I was thinking 200-300 basis points and using the S&P 500’s aggregate debt to determine the higher interest expense. The yield on high grade corporate bonds during 1991-2000 (period used to calculate the 2000 Shiller PE) averaged approximately 7.6% versus 4.4% during 2008-2017 (period used in today’s Shiller PE), or a 300 basis point difference. The 10-year Treasury’s yield averaged approximately 6.5% in 1991-2000 versus 2.5% in 2008-2017, or a 400 basis point difference. Inflation during these periods was approximately 2.7% in 1991-2000 and 1.6% in 2008-2017. Therefore, in real terms, rates used in the Shiller PE calculation in 2000 were approximately 200 to 300 basis points higher versus 2017 (depending on if you use corporates or 10yr Treasury). For what it’s worth, real interest rates in 2000 were near long-term averages, while in 2017 they are significantly below (goes without saying!).

Absolute Return Investor: Before you go through the hassle of calculating, you might want to run P/EBIT or EV/EBIT to see the output. I know you’re not stripping out taxes but those stats are probably easy to find.

Me: Right. A Shiller EV/EBIT would be nice!

Absolute Return Investor: As you already know, you will have to preempt the argument that today’s low rates make a higher PE more acceptable.

Me: True. And I’m also aware real rates and profits will never normalize again! 🙂 But my point is since real rates are significantly below average and are artificially suppressed, the Shiller PE may do a good job of normalizing earnings over ten years, but not normalizing real interest rates (there’s nothing normal about 0% real yields!). It just seems this market is more expensive than 1999-2000 (especially broadly speaking), but based on the Shiller PE, it is not. However, based on my calculations, most of this discrepancy appears to be due to lower real interest rates.

Absolute Return Investor: It’s a good idea. We made some calculations on median PE. I occasionally see references to median PE being higher than the tech bubble, but wanted to run the numbers myself. Verified. But your idea takes it a step further. The only issue with doing EV is it gets messed up with all the financial companies in the index. And that if you increase rates for borrowing costs you should also inflate bank profitability. I’m not saying I agree, but I often omit financials from my analysis like these.

Me: Good points and makes sense. My calculation also wouldn’t include the impact higher real rates would have on operating profits of non-financials. Maybe P/S remains the best aggregate valuation metric, which weeds out a lot of this and of course verifies what we already know – stocks are expensive! I suppose debating valuations and what year stocks were most expensive doesn’t really matter at this point, especially given positioning (almost all cash). It’s more out of curiosity. I’m confident my opportunity set is the most expensive it’s ever been…just trying to get a better understanding why some valuation measures are more expensive than others.

Absolute Return Investor: Plus, the Shiller PE is going to lose its utility in a couple years when the last recession’s earnings fall off.  Have you thought about a modified Shiller PE where the trailing period fluctuates to include two full business cycles? Or at least one? An arbitrary 10 year time period doesn’t hold up in extreme environments.

Me: That’s a great idea – including one or two complete cycles instead of a fixed 10 year period. I remember in 2015-2016 thinking the Shiller PE was including two periods of earnings booms and only one earnings bust. It wasn’t balanced or complete cycles.

Absolute Return Investor: Exactly. So what’s your adjusted Shiller PE look like?

Me: After normalizing real rates and adding 200-300bps to the S&P 500’s interest expense, I’m getting a Shiller PE of 39-46x, which is quite a bit higher than today’s 30x and similar to the 1999-2000 bubble peak. The calculation is an approximation as I don’t have a database on aggregate S&P 500 debt and I’m still without a Bloomberg. I backed into the S&P 500’s debt by using published debt to equity and price to book ratios. Again, not that any of these aggregate valuation measurements influence decision making…just helps support what we already know, but I think it’s interesting nonetheless.

Absolute Return Investor: Ha! You’re like an analyst operating using smoke signals without a Bloomberg. Very impressive. I believe it.

Me: Life without Bloomberg…it’s like that Seinfeld episode when Jerry shares his “moves” with David Puddy but withholds them from George. When George discovers, he gets upset with Jerry and yells, “I’m out there rubbing two sticks together while you’re walking around with a Zippo!”

Thanks for your feedback. Very helpful!

Stimulant Bender

Coffee and I have a long history of booms and busts. I love its taste and smell, but unfortunately I’m highly sensitive to caffeine and need to be prudent on how much I consume (ironic that I currently work out of a coffee shop!). Despite my best efforts, there have been times when I’ve overindulged and paid the price. One of my most memorable coffee moments occurred while visiting Philadelphia for a day of client meetings and presentations.

I arrived at my hotel late the night before and was rushed to make my early morning meetings. To save time I decided to order room service. When breakfast arrived I immediately noticed it came with a large pot of coffee. It smelled incredible, but I was reluctant to pour a cup due to my sensitivity to caffeine. However, given I was tired, I thought I could handle and possibly benefit from a half cup.

Although I hadn’t had coffee in a long time, it went down smoothly – too smoothly. It was so good I couldn’t stop. A half cup turned into a full cup and a full cup turned into two cups. Before I knew it, I finished the entire pot, or five cups of coffee. Now that was a delicious breakfast! And even better, I apparently overcame my sensitivity to caffeine. Feeling full and refreshed, I looked at the clock and rushed to my presentation.

Fortunately my first meeting was right across the street from the hotel. I arrived just in time and sat in a boardroom with a group of consultants. As we enjoyed some small talk, I began to sense something was wrong. I started to feel warm and began to sweat. What was happening? The office was cold so it wasn’t the temperature. Was I nervous? I didn’t think so as it was a friendly crowd and it’s a presentation I’d given hundreds of times. And then it hit me – oh no, I may have drank too much coffee! Just as I made this realization a tidal wave of caffeine crashed over me and my presentation began.

After being introduced, I was asked to tell everyone about my absolute return strategy. “Tell you about my strategy?” I thought, “I don’t even know my name!” My heart was racing and I was having trouble concentrating. I wanted to, but was unable to say, “Excuse me, but I just drank a pot of coffee and I’m seriously considering running through that wall behind you.” Finally some words came out and I gave an hour presentation in 15 minutes. I concluded by asking, or yelling, “Questions, questions, questions?! Thank you!!!”

My sales rep rushed me out of the meeting like a shot president. Once safely in the elevator she asked, “What was that?” I replied, “That was a pot of Philadelphia’s finest coffee.” Needless to say, from that day forward, I was back on the coffee wagon and sentenced to a life of green tea.

Although I didn’t need to drink an entire pot of coffee make this point, overdosing on caffeine was a good reminder that there are limits and when those limits are exceeded there are consequences. Because I didn’t feel the effects after my first cup, I thought it was safe to drink another cup. And after my second cup I still felt okay, so I thought it was safe to have a third. And this line of thinking continued until the entire pot of coffee was gone. While the consequences were delayed, my sensitivity to caffeine did not miraculously disappear and this time would not be different.

Speaking of overdosing on stimulants, several Federal Reserve members spoke publicly this week. For the most part, central bankers continue to go about their business as if they didn’t serve investors five cups of monetary coffee. Fed members recently increased their hawkish tone, raised rates 25 bps, and continue to discuss plans to reduce the Fed’s balance sheet. In their eyes, and in the eyes of many market participants, central bankers are firmly in control of the financial markets and their exit strategy.

On Monday, San Francisco Fed President John Williams stated the U.S. economy is “about as close to” the Federal Reserve’s goal of maximum employment and 2% inflation “as it’s ever been.” This made me wonder, if the economy is as close to the Fed’s goal as it’s ever been, why does monetary policy remain so close to where it’s never been?

In his speech, Mr. Williams provided clues as to why monetary policy remains so accomodative. Specifically, he acknowledged concerns that the normalization process could cause “market turbulence”. He reassured investors by saying, “The last thing we want to do is fuel unnecessary or avoidable volatility or disruption—whether we’re talking about domestic markets or international markets.”

Based on recent comments from Fed members, it appears the Federal Reserve’s main tool to combat potential “volatility and disruption” in financial markets, is to normalize policy gradually and be transparent. Mr. Williams stated, “The more public understanding, the less chance that said actions will fuel unnecessary volatility in the markets.”

I can’t help but be reminded of 2004-2006 when Greenspan took a similar gradual and transparent path (I call it “pretty please” monetary policy). After raising rates in 2004, Greenspan communicated to the markets that increases in interest rates “are very likely to be measured over the quarters ahead.” Gradual and transparent is what Greenspan wanted and it’s exactly what he delivered. The Greenspan Fed raised rates at a measured pace for 14 consecutive quarters before passing the monetary baton to Bernanke in 2006.

Initially Greenspan’s transparent and measured approach was successful in promoting further asset inflation and credit growth, but in the end, it was unsuccessful in painlessly deflating the equity, mortgage, and housing bubbles. Eventually years of easy money and credit caught up with the Fed as its measured and transparent approach failed, while “unnecessary volatility” prevailed – overwhelming investors and policy makers.

Similar to 2004-2006, investors currently do not appear threatened by the Fed’s measured and transparent (predictable) normalization process. In fact, based on asset prices and valuations, investors appear to believe the normalization process is “transitory” and more, not less, stimulative policy is on the way.  And they may be right. Who doesn’t believe a pot of QE4 will be brewed during the next market correction?

As the Federal Reserve attempts to exit from years of record low interest rates and previously unimaginable asset purchases, I’m reminded of my experience with overdosing on caffeine. I have unfortunate news for the Fed. There is not a safe exit from a stimulant binge – even if you stop, the effects are already in the system. In the case of the Fed, their relentless doses of monetary caffeine have already significantly altered interest rates, asset prices, capital allocation decisions, and balance sheets. The only uncertainty, in my opinion, is how many more cups of monetary stimulus can be served before investors realize something is wrong, get jittery, and cause the central banks to lose control.

As I’ve been recently diagnosed with chronic central bank fatigue syndrome (CBFS), I’ll be back to writing about individual businesses next week. We’ll have more substantive news to discuss and analyze soon as earnings season is approaching — I’m really looking forward to it. Have a great weekend!

Energy Checklist

I’m working on several beaten down energy stocks this week and won’t have time to post. That said, I thought I’d put together a quick checklist of some of the things I’m looking for in potential energy investments.

  1. Companies that took advantage of the recent rally (generosity of dip buyers) and issued equity above net asset values. In several instances, energy stocks are trading well below the prices of 2016-2017 equity offerings. If an energy business was able to improve its balance sheet or buy distressed assets with equity proceeds, its net asset valuation may deserve a boost (due to lower financial risk and issuing equity above intrinsic value).
  2. Companies that extended their debt maturities/maturity wall. I continue to be amazed by the level of generosity in the credit market, especially given how close many energy companies came to bankruptcy. Specifically, I’m looking for companies that successfully extended maturities to 2022-2025 and with untapped credit lines. Several debt and equity offerings were used to pay down credit lines, which allowed many banks to dodge the energy credit bust bullet. I’ll most likely avoid companies that were unable to refinance debt over the past 1-2 years on favorable terms – it’s a red flag.
  3. Companies that hedged a significant portion of 2017 and 2018 production at favorable prices. During sector troughs it’s about surviving, not thriving. Cash flow insurance helps.
  4. Companies with net debt to discretionary cash flow of 3x or less (using current commodity prices).
  5. Avoid energy stocks that could double or go bankrupt within a year. I call this coin flip investing. Energy companies that I consider coin flips are often reliant on near-term commodity prices for survival. I only want to consider energy companies that can survive an extended period of depressed commodity prices. On a side note, while coin flip investments are not appropriate for long-only absolute return investors, they may be an interesting speculation for certain option strategies (simultaneously buying puts and calls).
  6. Companies that can survive by drilling within cash flow. In other words, companies that are not reliant on fickle bankers or the bond market and can pay their bills with operating cash flow.
  7. Avoid valuing energy companies on cash flow. In my opinion, this creates too high of a valuation during booms and too low of a valuation during busts – it encourages buying high and “freezing” when prices are attractive. I prefer a net asset valuation based on replacement costs as I believe it’s a less volatile and more accurate valuation methodology.
  8. Avoid finding comfort in large discounts to net asset values without sufficient liquidity. It doesn’t matter if the business is selling at a significant discount to net assets if the business doesn’t have the necessary liquidity to survive. Tidewater’s (TDW) recent announcement to enter Chapter 11 is a good example. As of 3/31/17 Tidewater’s book value was $35/share and its stock is currently trading at 80 cents. I wrote about energy stocks and Tidewater in the following post: You Got Your Chocolate in My Peanut Butter
  9. Avoid extrapolating. Energy stocks are often either significantly undervalued or overvalued – rarely do they trade near fair value for long. In my opinion, these are not buy and hold investments and an area where active management can add considerable value. Take risk when getting paid during the busts and avoid the temptations of holding throughout the booms (For what it’s worth, I’ve found selling in the booms is often harder than buying during the busts – greed can be so powerful!). A rule of thumb I’ve often used is be cautious when commodity prices are 2x the costs of replacing reserves and production (additional supply and the next bust is usually on the way).
  10. The bottom in energy prices and energy stocks is almost impossible to predict. Be prepared to suffer large unrealized losses as you wait for the cycle to run its course. Low prices and tightening credit should ultimately reduce supply, leaving survivors with strong balance sheets in a favorable position. Lastly, if you miss the bottom, do not worry, the energy industry is home of second chances! Given the energy industry’s obsession with production growth and the financial industry’s obsession with funding that growth, higher supply and the next bust is usually right around the corner.

In conclusion, I’m currently looking for energy companies trading at a discount to my net asset valuation with strong enough balance sheets to make it through the cycle. Given most energy company balance sheets continue to have too much debt, I plan to be very selective and do not expect many energy companies will pass my checklist. That said, I’m hopeful the current mini-bust gathers momentum and provides absolute return investors with an improved opportunity set. Although sector bear markets are often very narrow, they can also be very rewarding. Happy hunting!

Mo’ Margins Mo’ Problems

Investors have a tendency to gravitate towards leading brands and high margins. Such traits are often an indication of a high-quality business and meaningful intangible assets. While brands can be very valuable, they are not free. Brands require considerable investment and ongoing maintenance. Furthermore, similar to many things in business, there are cycles, trends, and risks associated with even the best brands. For example, many consumer brands have recently faced challenges as consumer perceptions, behaviors, and spending patterns change – few are immune. In fact, one of the strongest consumer brands I follow, Ralph Lauren (RL), recently reported a -16% decline in quarterly sales as it responds to structural shifts in retail.

The value of a brand fluctuates and is subjective. If a company places too high of a value on its brand, it may price its products or services too aggressively, risking sales and distribution relationships. The price difference between premium brands and lower quality brands or private label is also known as the price gap. The price gap is a very sensitive issue and risk for businesses with leading brands. If the price gap is too low, the company risks receiving an inadequate return on assets (the brand). If the price gap is too high, the company risks losing volume and customer loyalty. 

For example, my favorite ice cream is Publix GreenWise, a private label brand. I tried GreenWise after Breyers increased the price of their ice cream via smaller packaging (half gallon to 1 ½ quarts). In effect, the price gap between Breyers and Publix’s private label brand became too large and noticeable, so I gave the GreenWise brand a try. To my surprise the alternative was very good, and in my opinion, even superior (in taste and organic ingredients) to the more expensive leading brand.

Another risk consumer brands face is increased competition and consolidation within the retail industry. Bloomberg recently wrote an article discussing the growing threat of European grocers entering the U.S. market (link). As retailers and grocers are being squeezed by aggressive competition, their suppliers, including leading consumer brands, should also expect to be squeezed. As such, it may become increasingly difficult for leading brands to gain market share, raise prices, and maintain above average profit margins.

To illustrate, imagine you’re a grocer with low single-digit margins and European grocers are entering your markets. Keep in mind the strategy of your new and aggressive competitor is to take market share by undercutting you on price. Now imagine a branded company with 15-20% operating margins, a healthy dividend, and large buyback program coming to you and requesting a price increase necessary to maintain their margins. It’s similar to a wealthy 1%’er with a portfolio of FANGs asking the 99% for financial aid!

The J. M. Smucker (SJM) Company reported earnings last week and discussed many of these competitive issues. I consider J. M. Smucker to be a good business with many leading brands. That said, they’re currently operating in a challenging environment, with organic growth slowing to a crawl. Specifically, sales are expected to grow 1% in 2018, with EPS increasing 2%-4%.

On their quarterly conference call, management was asked if the pricing environment has become more challenging. Management noted they have heard about “additional pressure” but they have been successful in pushing through price increases. That said, they acknowledged it is taking a little longer to get price adjustments through with a couple larger customers.

Management was also asked about growing promotions in private label. They responded their customers view private label “as one of the arrows in their quiver to get them price points to compete with those channels [discount grocers and retailers]. And so we’ve seen aggressive activity in all the commodity-based things, in coffee, and across a number of different categories, right? So are we concerned about that? Yes.” Management went on to note they are fortunate to be the leading brand in their core categories.

On the pricing gap between their brands and private label management stated, “We understand what price points we need to hit on that product to maintain the right pricing gaps. In the vegetable oil business, we understand — we have great detail on the gap we need to have with private label. We can be above private label in all of those cases, but we can’t let those gaps get too large.”

As competition and consolidation in retail increases, leading brands will not be immune to volume and pricing pressures. Last week I discussed Casey’s General Stores (CASY) and how their customers are moving away from cigarette cartons to packs. Management also mentioned the shift from brands to generics. To slow this trend, leading brands will need to monitor their pricing gaps closely. If they maintain or increase the pricing gap, lower sales and volumes should be expected (Ralph Lauren is a good example). If the pricing gap is reduced to maintain volume and market share, margins could suffer.

While investors are attracted to leading brands and attractive profit margins, in the current consumer environment, I believe elevated margins should be analyzed carefully for sustainability and trend. High margins have always attracted competition; however, given current pressures on consumers and retailers, it may be purchasing managers that becomes the bigger threat. Given the difficulty many brands are having growing volume and passing on price increases, it appears this process may be well under way.

The Marlboro Red Consumer Sentiment Indicator (MRCSI)

After last earnings season I noted without a strong rebound in consumer spending, I expect aggregate earnings growth to slow later this year (especially if declining energy prices cause credit to tighten). While asset inflation remains unchecked, consumer spending does not appear to be responding or accelerating. Two consumer companies on my possible buy list announced earnings this week – both suggest the operating environment remains challenging.

Casey General Stores (CASY), the convenience store operator, reported results on Monday with sales and earnings that were less than expected. Specifically EPS declined to $0.76 from $1.19 during the quarter and $4.48 vs. $5.73 for the year. During the quarter, same-store fuel gallons declined -0.5%, while grocery same-store comps increased 1.5% and prepared food/fountain comps were up 3.2%.

Management noted that similar to others in its sector, Casey’s “experienced downward pressure on customer traffic which had virtually impacted same-store sales across all of our categories.” Management blamed decelerating customer traffic on the weak agricultural economy, the difference in food away and food at home prices, and competitor promotional activities.

Management commented further on the agriculture economy saying, “The USDA anticipates either a flat to slightly declining farm income in calendar 2017. So we’d anticipate this piece of the challenging environment to continue to at least to the end of the calendar year.”

Labor costs were also discussed, with management calling labor very tight and wage pressures challenging. I thought the following comment was interesting, “It’s not uncommon for people to jump ship for $0.25 raise here and there, and so that has been a challenge.”

One of my favorite economic reports, the Marlboro Red Consumer Sentiment Indicator (MRCSI), was mentioned again this quarter and continued to suggest the consumer remains cautious. Management commented, “I mean one of the things that we faced in the cigarette category, we do see, albeit it’s gradual but it’s been continuing for the next several quarters, a movement away from carton to pack purchasing. We’ve also seen it moving away from full value purchasing to a more discounted brand, which could be a generic brand.”

And finally, management had some interesting comments on their fiscal 2017 expectations versus actual results. Management explains, “…there’s no question that when we put our goals out for fiscal 2017, I’m not sure we fully anticipated the customer response, the consumer response I should say in relation to the economic conditions.” Management went on to note they are taking economic conditions into account more this year than they did last year.

Although Casey’s stock declined 8% on the news, trading at 18x EV/EBIT, it continues to trade over my estimated business valuation. Casey’s is one of the many high-quality companies I follow and like, but in my opinion, remains too expensive to generate future adequate absolute returns. Hence, it remains on my possible buy list, but not in my portfolio.

United Natural Foods (UNFI), the distributor of natural and organic foods, also announced earnings results this week. Although results appeared as expected, annual sales guidance was revised lower and its stock declined -4%.

Management noted the grocery environment remains challenging (side note: Isn’t it interesting restaurants often blame grocery stores for taking market share, yet grocers continue to struggle? Maybe it’s not where the consumer is spending, but how much the consumer has to spend).

Specifically, management stated, “Net sales finished below our expectations in the third quarter driven by broad-based retail softness, the rationalization of business in conjunction with our margin initiatives and lack of inflation.”

“Same-store sales in many of our retail customers were under pressure or negative during the quarter. Our retail customers are facing competitive pressure not only from other food retailers but also from many channels now carrying assortment of better-for-you products.”

“…when you look at general same-store sales and year-over-year, quarter-over-quarter, many of the retailers across most of the channels are facing some real headwinds in terms of growth. And as part of that, we’ve seen certainly a fair number of store closings as retailers are coming together. And so in the near term, that’s been a real headwind for us.”

Kroger reports next week, hopefully providing us with more useful grocery and consumer data points. That said, for those waiting for the consumer to get the U.S. economy out of its 1-2% growth funk, further patience may be required. From a bottom-up perspective, I’m not seeing it.

FANGs or Patience = 5 Stars or 1 Star

Since I didn’t have time to check on the markets last Friday, I turned to financial television for a quick update. I watched three networks and all were discussing the same topic – record high stock prices and the FANG stocks.

Technically the FANG stocks include Netflix. No offense Netflix, but your market cap of “only” $71 billion is a small cap relative to other FANG members ($480 to $810 billion market caps). I consider Apple, Microsoft, Amazon, Facebook, and Google the official FANG gang. Together they make up approximately 40% of the Nasdaq 100 and $3 trillion in market capitalization (similar to the size of Germany’s economy). When market caps get this big, I like to value stocks relative to the cost of a modern aircraft carrier. Move over Shiller P/E, meet the AC (aircraft carrier) ratio. Currently, the FANGs are trading near 230x aircraft carriers — a record high and clearly a world superpower.

For many portfolio managers, the decision to own the FANGs is not an investment decision, but a risk management decision – as in, the risk to relative performance and risk to assets under management.  

To illustrate, let’s assume the FANGs are significantly overvalued and are selling at 2x their intrinsic value. With this assumption in mind, would a portfolio manager be better off buying the FANGs or holding cash? Holding cash would seem to be the obvious choice, but not so fast. From the perspective of a manager focused on relative returns, holding cash instead of a rapidly inflating asset may be too risky. In effect, does the relative return manager assume the investment risk of owning the overvalued FANGs or assume the career risk associated with holding cash? I think we know the answer. As Jeremy Grantham wrote, “Career risk is likely to always dominate investing.”

While the financial media focused on the FANGs and record stock prices last Friday, I enjoyed a pair of articles discussing the benefits of holding cash. On a day of considerable asset inflation and predictable market commentary, I found both articles to be refreshing reads.

The first article was by David Snowball of The Mutual Fund Observer. In his article, “The Dry Powder Gang”, David discusses the contrarian viewpoint of holding cash. He also provides a list of mutual funds that continue to practice patience (I’m often asked who is willing to hold cash, so thanks to David for providing his list).

In addition to discussing the benefits of practicing patience, David points out the challenges professional managers face when holding cash. He writes, “They bear a terrible price for hewing to the discipline. Large firms won’t employ them since large firms, necessarily, value “sticky assets” above all else. 99.7% of the investment community views them as relics and their investors steadily drift away in favor of “hot hands.”

However, as David explains, there remain a few managers that are willing to assume considerable career risk in order to protect shareholder capital. David states, “They are, in a real sense, the individual investor’s best friends. They’re the people who are willing to obsess over stocks when you’d rather obsess over the NFL draft or the Cubs’ resurgence. And they’re willing, on your behalf, to walk away from the party, to turn away from the cliff, to say “no” and go. They are the professionals who might reasonably claim…we’ve got your back!”

David is one of the few mutual fund analysts who closely covers absolute return funds and funds that hold cash. His site is a great resource for those wanting to learn more about unique non-index hugging funds.

David Snowball’s article and website

One of my favorite absolute return investors, Frank Martin, also recently wrote about the benefits of cash. He views cash as a call option. Frank writes, “Current investment conventions maintain that cash—or, in my case, a portfolio of laddered short-term US treasuries—is a static holding. That’s a rather unimaginative perspective. Entertain the following thought: Cash is an option that can be valued. Think of it as a call option on any asset, with no expiration date, and with no strike price.”

When investors think of holding cash in a period of sharply rising asset inflation, they often think of opportunity cost. Frank thinks of cash differently and reminds us that while investors holding cash may incur a “temporary sacrifice of return” they are also positioned to take advantage of future opportunity. As the number of opportunities increase, so does the value of cash optionality.

Frank explains, “With market overvaluation induced by the current Fed policy and tail risks high, I think the price of the above-described call option is well below its intrinsic value. If that which most investors think improbable, or even impossible, happens (think no farther back than to 2006-2007 for the most recent extraordinary popular delusion – not counting today), the value of cash as a call option will skyrocket. In the irrationality of the moment, investors will sell other assets at absurdly low prices to acquire, of all things, cash!”

Frank also provides an answer to a question I’ve been asked frequently over my career, “Why should I pay you to hold cash?”

Frank writes, “Of course, most investors think they are not getting their money’s worth when they see their investment manager holding large amounts of cash. Some ‘enterprising’ investors may gradually realize instead that they are paying someone who has demonstrated the necessary expertise to buy cash as a call option when it is utterly out-of-favor and thus compellingly cheap, despite the agonizing wait for bargains to appear.”

Frank goes on to quote Nassim Taleb who wrote, It’s much easier to sell ‘Look what I did for you’ than ‘Look what I avoided for you.Of course a bonus system based on [short-term] ‘performance’ exacerbates the problem. I’ve looked in history for heroes who became heroes for what they did not do, but it is hard to observe nonaction; I could not easily find any.” [my emphasis]

Frank concludes, “Look what I’ve avoided for you” falls on deaf ears when the auction crowd is bidding up prices to ridiculous heights.  During those times it is nonaction—keeping the bidding paddle in one’s pocket—that can become the stuff of which tomorrow’s heroes are made. Self-control, understanding, compassion, patience —and a thick skin—are most of what is required to stay the course.”

Well said! To enjoy Frank’s entire article and check out his new blog please click on link below.

Frank Martin: Cash as an Option


Conversation with Jesse Felder

Below is a link to a recent conversation I had with fellow absolute return investor Jesse Felder. If you don’t follow Jesse’s work I strongly recommend it — he’s a great resource and a very knowledgeable investor. In addition to his website (The Felder Report), he’s active on Twitter. I really enjoyed our conversation and I hope you will as well. We discuss numerous subjects relevant to today’s markets and absolute return investing.

Jesse Felder Podcast

Retail Survivor

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

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

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

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

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

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

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

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

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

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

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

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

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

Hop on the Bus, Gus

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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


Don’t Forget to Stretch

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

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

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

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

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

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

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

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