Q&A

As Q3 earnings season approaches, there is a drought of company-specific news and events to analyze. Regardless of the lack of fundamental data points, investors appear committed to positioning themselves for another end of the year entitlement rally. I continue to have no opinion on the market’s near-term direction, but a year-end performance panic wouldn’t surprise me. During the current market cycle the S&P 500 has increased seven of the past eight Q4’s, averaging slightly over a 6% gain. This cycle’s only negative Q4 was in 2012 with the S&P 500 declining -1%.

While equity investors enjoy daily record highs in the popular benchmarks, I continue to patiently wait in low yielding cash and cash equivalents (granted, yields are thankfully moving higher). As an investor uninterested in owning equities, it’s a rather uneventful and boring period of the market cycle. While I acknowledge stocks could go higher, I remain committed to a process and discipline that requires an adequate absolute return relative to risk assumed.

Considering the lack of information coming from companies and the markets, I thought today would be a good time to share some questions I recently received from readers and my responses. I selected questions I receive frequently, are useful in helping understand my absolute return process, and address the current environment. As always, feel free to email me with any questions and comments.

Q: See anything or any sector that is somewhat interesting?

A: Since energy has rebounded, I’m not finding much. Actually almost bored to tears. Considered buying S&P 500 call options to cause the market to crash! Seriously…extremely boring market.

Everyone KNOWS markets are going to rally into year-end. And they certainly could…year-end performance panic has happened seven out of the past eight Q4s during this market cycle.  Only down Q4 was 2012 with -1% decline. You have to wonder if this concerns central bankers – the environment they helped create. While a stock market that never goes down may be what they want, the complete lack of volatility and pureness in asset prices must be concerning.

Q:   In regards to your most recent blog on inflation, other than government data, have you come across data points that suggest inflation isn’t going to increase?  Also, suppose you knew inflation would increase with 100% certainty, how would that change the way you invest?  What companies would you gravitate towards?  What securities would you gravitate towards?

A: Yes, there have been some areas where price is not increasing or even decreasing. Often these areas are found where there is too much capital/over supply (energy bust 2014-2015 good example). Food was also a good example, until KR reported this quarter that trend has reversed. While there will always be cycles within certain industries causing inflation to fluctuate, I’m currently noticing more signs of rising costs than declining. I suspect this will continue in Q3, especially with higher energy prices vs. Q2. We’ll see…still need more data points to come to a conclusion.

I currently have a very patient position (liquid and waiting) and I’m not making investment decisions based on my inflation views (volatility in cost and price should be included in your required rate of return and normalized cash flow assumption). My main issue remains valuations. Small cap valuations are high regardless of my view on inflation.

That said, I think it’s important when valuing individual businesses to understand how margins are or have been impacted by inflation or deflation. For example, many companies dependent on natural gas have benefited from abundant supply. A chemical company would be a good example. Or how about PZZA and cheese prices? In effect, when normalizing margins I believe it’s important to normalize input costs as well. I believe extrapolating low input costs (including labor) indefinitely carries risks and assumes margins will remain elevated indefinitely.

Hope this helps. Looking forward to Q3 earnings season and more information.

Q: How did you form your investment philosophy?  Did you try other forms like GARP or relative valuation before?  How do you think about position sizing?  And selling?

A:  Great questions. The process question can be found by reading through my blog as I touch on it in several posts. I particularly recommend the post “What’s Important to You”.  I plan to do a post on my sell discipline soon…that would be a 1000+ word email, so I’ll let you know when I post.  Position size has to do with risk/return and quality (degree of operating and financial risk)…that’s a good post topic as well I’d like to address. Really enjoyed the article on cheese you sent…7% margins seem reasonable for a monopoly! MSFT’s much higher!!!

Q:  If you are right and there is an unexpected bout of cost-push or other consumer price inflation in our near-term future, I think the game is over. After all, what options does the Fed have if inflation becomes the problem, not disinflation? I can’t think of the Fed being in a more difficult position: stagflation.

A: We’ll see what Q3 earnings season says about inflation. I’m not sold on the inflation accelerating idea yet, but definitely noticing more signs. I need more data to conclude. Also, for what it’s worth, so far I’m not seeing a noticeable earnings catalyst on the upside or downside in Q3. I think the greatest threat to stocks near-term won’t be earnings, but that stocks simply quit going up for no specific reason (old age and fatigue). And on the potential for more upside we have the good ol’ year-end performance panic by the “pros”.

Will be interesting next several months. I think as long as stocks go higher, rates continue to increase…a nice game of chicken could be forming between the stock and bond market! 2yr yielding approx 1.5%…I view gradually increasing rates as a raise so in an indirect way I’m benefiting from expensive equities getting more expensive. Asset prices and the economy are one trade, it seems. As long as asset prices remain inflated, I think the Fed will have to keep raising rates…especially if my theory on rising costs receives more supporting data in Q3.

Q: Do you know of good, niche conferences for small caps or small and mid-caps?

A: I do not go to conferences. I did earlier in my career, but as my possible buy list has grown I’ve found calling companies to be the only way I can keep up vs. visiting companies or conferences. That said, if an industry were to get extremely depressed, I’d be interested in attending. Great way to see a lot of companies in one industry at once.

Q: If you think about it, that’s the mechanism that would catch the majority of people off sides, just enough growth to give confidence that the market has more room to run and suck everyone back in before an unexpected pop in inflation and rates.

A:  I agree…how fitting would it be for this nontraditional cycle to end in a traditional manner! We’ll learn more once Q3 earnings are released…right now I’m just noticing a change in trend. Degree and consistency is still uncertain, in my opinion. That said, my water utility bill just went up 8% and my favorite “cheap” taco joint just raised their chicken soft tacos by 7%!!! So maybe I’m biased.

Q: Would you consider investing in overseas market or build your competency in these regions?

A: While I think there may be more value in international stocks vs. US equities, it is outside of my expertise. My focus is on domestic US small cap stocks. I believe staying focused on a relatively fixed opportunity set over many years provides me with a competitive advantage. In addition to having a better understanding of their businesses and appropriate valuations, I believe my familiarity will allow me to act more decisively when opportunities return.

Hopefully specializing on the same stocks for decades pays dividends when this cycle ends! Currently my beliefs on my opportunity set being grossly overvalued has only forced me to recommend returning capital and being unemployed 🙂Really looking forward to this cycle ending…just wish I knew when.

Q:  I would like to know if you could share with me some books that really changed your view about finance.

A: I don’t have a lot of book suggestions. I spend most of my time reading about individual businesses. In fact, that would be my recommendation…read as many 10-ks as you can on different companies and as you read them try to determine how you think they should be valued. The best investment process is one you develop and believe in, in my opinion. I wrote a post “What’s Important to You”…you might want to check it out.

Q: In your opinion, do you foresee a specific catalyst responsible for the coming downturn in the cycle? Could it be the Fed and their quantitative tightening and balance sheet reduction programs? What are your thoughts on the argument that we need to adjust to a new low interest environment (has the game actually changed)?

A:  Sometimes cycles end with a catalyst (2007-2008 Bear Stearns/Lehman) while other cycles they just die from old age/no catalyst (March 2000). It’s tough to say. If I had to guess, one day you’ll come into work and everything will change. What that catalyst will be for certain is unknowable, in my opinion. It’s such a unique cycle as we’ve never seen central banks act in this manner before…no real history to guide us.

Ideally this cycle ends due to the loss in faith of central bankers. If this is the case, I believe the decline will be more enduring and create more opportunity. In other words, the decline won’t be rescued by central banks as they’ll be viewed as the problem, not the solution. Furthermore, without central bank interference, I believe free markets and capitalism will be more effective and productive in properly allocating capital (what I once did for a living). But all of this is really out of my expertise. All I really know is prices within my opportunity set are expensive relative to risk assumed and if I were to get invested today I’d most likely lose money and would not be in a position to generate attractive absolute returns.

As far as rates staying low indefinitely…it’s possible. But if that’s the case, growth rates would also most likely remain depressed. Risk assets are pricing in strong growth (highest valuations in history do not go well with no growth). I’m optimistic the interest rate and market cycles have not become extinct…if so, how boring and how sad – investing as we know it will have died. In any event, fortunately your questions will be answered over time…I wonder the same things and can’t wait to know the answers. I suspect when your questions are answered, our opportunity sets will look much different…thankfully!

Q: I don’t understand what you meant by profit cycle. Are you saying that all businesses and sectors have their own profit cycles that you can reasonably assume to repeat cyclically? Also you said that you want to know everything about the business that determines normalized margins which determines normalized FCF. By normalized, do you mean factoring in where the business is in its current profit cycle?

A: Yes, I’m talking about the profit cycle of business, industry, and aggregate profits. Think of an energy service company like HP. During the peak they make about $6/share in earnings. During the trough they make $0.  If you value their business using peak earnings you’ll get a very high valuation, while if you value using trough you’ll get a very low valuation. I prefer normalizing, or using what I believe annual free cash flow will be on average over a cycle. While I’m simplifying here to make a point, in HP’s case that would be closer to $3/share. In my opinion, normalizing provides me with a more accurate valuation as I have a more accurate estimate of what cash flows will be over an entire profit cycle, not just one point in time. Hope this helps. Thanks for the email and question.

Q: You wrote, “A central bank’s balance sheet is entirely different. In theory, a central bank’s balance sheet can expand indefinitely as there is no limit to the amount of money it can create to purchase assets.” My understanding is that every dollar the central bank creates actually gets its value by stealing value from existing dollars, IE inflation. If my understanding is correct, if the central bank were to continue creating infinitely more money, would that money not become infinitely less valuable through inflation?

A: Great question. You are correct. While central banks have an unlimited ability to create money, doing so should devalue the currency. However, as all of the major central banks have QE’d together, or have taken turns monetizing debt, the major currencies have not devalued meaningfully relative to one another. Furthermore, today’s inflation to date has flowed mostly into stocks, bonds and real estate. In other words, instead of our dollars buying significantly less goods and services, they buy less assets; hence, the term asset inflation.

So yes, our dollars are worth less today, but the inflation has been focused in asset prices. I don’t know how this cycle ends, but I suspect it will be related to the failure of central bank policy. I don’t believe money creation creates value as it does not require effort or sacrifice – it just doesn’t pass the common sense test, in my opinion.

What a great time to be studying economics! I bet they don’t have many books discussing global QE! I think there will be plenty written after this cycle ends.

Q: A question I do have is for normalizing cash flows do you use Ben Graham’s time frame in Security analysis of 7 years? He mentions this is not too long to include things that no longer affect the business but its a long enough period to get the normalized earnings over a cycle. What would your take be on that?

A: Great question on time period. I customize per business valuation. Some cycles are longer than others. For example an energy service company may have a much shorter cycle than a grocer. Not a great example but you get the point. I’d say most cycles are 3-10 years. And of course this cycle longer than most!

Q: I was wondering if you wouldn’t mind saying how old you were when you were in the CFA program? Also, if you would recommend going through the program in today’s environment?

A: I was 22 when I took the CFA and finished when I was 25 (definitely recommend taking before staring a family!). I think it’s a good program and glad I went through it…I found about 1/2 of the information useful which is pretty good. Tough call on going through the program today. If asset prices never go down again and markets remain overly influenced by central banks, I’d say no…find something more productive to do with your life (if you go into carpentry let me know…need a new chimney and we can’t find anyone…labor market very tight here!). However, if history repeats, central banks lose control, and free markets return, I think studying investing makes a lot of sense…assuming that’s your passion. For what it’s worth, I think free markets will return. I just no idea when or how high asset prices go before the cycle ends.

Q: Based on Graham’s book we have created a spreadsheet to analyze companies based on Graham’s principles plus a few criteria of our own. Could you take a couple of minutes to see if you have any major updates you would add to the attached spreadsheet?

A: When viewing historical results I always like to include the good and the bad. A fixed time frame, such as 5-years in spreadsheet doesn’t always include the peak and the trough. I prefer customizing to include an industry trough or recession. This way you won’t be blindsided when the next trough occurs. Maybe throw in 08-09 in your analysis, or a cash flow estimate you expect during the next recession.

Q: By the way: I’ve read your blog posts, but also a couple of interviews. Maybe it’s just my failing memory, but did you ever go into your “sell discipline”?

A: Good question on the sell discipline. I don’t think I’ve written about it on the blog, but it’s a good topic and I’m glad you brought it up. I’ll put it on the list of topics I want to discuss.

Thankfully, most of my sells were a result of the stock price reaching or exceeding my valuation. So that’s the most common and preferred reason I sell. However, things do go wrong. When I can no longer value a business with a high degree of confidence I often sell. By this I mean when I’m forced to speculate versus invest. This could be due a large portion of revenues becoming uncertain (usually permanent loss such as lost contract or law suit) or normalized margin assumptions become too difficult to predict.

I also sell when my financial risk limits are exceeded (3-5x discretionary cash flow). This happened to an energy stock in 2014. They took on too much debt and leverage exceeded 3x cash flow. In this case my sell discipline protected capital as I sold around $20 and stock eventually declined to $3 (due to balance sheet and declining cash flow). But I’ve had the reverse happen too, when I’ve sold due to financial risk and the stock rebounds or is taken over. Regardless, I don’t want to own a business if they can’t pay their debt off in 3-5 years internally. Most small cap maturity walls are around 3-5 years out.

Finally, there are also times when I get the valuation wrong and my new valuation drops below the stock price. This happens less frequently, but it happens. When my valuation is in decline it means I got something wrong. If my new valuation remains above the stock price I’ll continue to hold the stock, but I won’t add to it until my valuation stabilizes.

Wow, didn’t mean to, but it appears I just wrote a post on my sell discipline.

Q: With the money my tightfisted friend no doubt squirreled away during his Halcion years, and a track record that is more than credible, maybe you have thought about teaching at one of the better graduate business schools?

A: If I was as smart as you I’d love to teach. Keep in mind I’m a product of the Kentucky public school system and former hair mullet member…hardly professor material! 🙂

Q: When you are looking at DCF, outside of managers directly saying on an earnings call what their maintenance capex vs. growth capex looks like, how do you distinguish the two? Do you even try to distinguish the two if not specifically mentioned by managers?

A: Good question. There are times when management overdoses on cap ex and has depreciation expense above maintenance cap ex. If it’s a large number I may add back to free cash flow a few years, but typically won’t do it long-term…but this is rare. Normally I base free cash flow more on after tax EBIT than EBITDA minus maintenance cap ex.

I’ve found managements tend to have a way of underestimating maintenance cap ex, but they can often run lower cap ex if needed (often in times of distress – see energy 2014-2015). I like to think of it as distressed cap ex, or how much cap ex they could spend just to keep things afloat. But if you do this, I think it’s only fair to lower growth rate assumptions…there are no free lunches when cutting back on investment.

Pet peeve of mine is using EBITDA to value energy companies when majority of EBITDA is depletion. Rarely do energy companies fail to reinvest depletion…most spend more. If it’s an expense and shareholders will never see it, why capitalize it? I prefer replacement value of reserves (interesting topic I’ll address soon in blog). In any event great question. As always, there’s not always a strict rule of thumb when it comes to investing and valuation. I always like to customize valuations on each business to fit what makes most sense to me.

Q: Have you ever seen this chart before?

Chart

A: Excellent chart. Shows overvaluation broader this cycle. In my opinion, “the market isn’t as expensive as year 2000” argument has a lot of holes in it! Thanks for sending.

Q: Now I have also bought Foot Locker (FL) and Hibbett Sports. Both great balance sheets, for both the latest few quarters were not so great. But does this really justify a crash of more than 50% in half a year?

A: Interesting. I’ve been looking into retail and energy. Currently working on HP, but I plan to look for beaten down retailers with good balance sheets next. I missed DSW’s move, but just like energy…usually retail gives you plenty of second chances!

Q: I have allocated 20% of my portfolio to small caps as a way to diversify, am I putting my money at risk doing this when we make a downturn? I am wondering if I should shift those investments to my SP500 index funds?

A: Yes, small caps carry risk…always have, always will. Many don’t make money, but many do…often depends where we are in the profit cycle. Currently profits and margins are high on average…and so are prices (at record highs), but that doesn’t mean prices can’t go higher. The risk of small caps often varies with the price you pay. You or your adviser should determine your appropriate risk level…unfortunately I can’t do that for you as I can’t give investment advice or make specific recommendations on funds or stocks. Good luck…it’s an interesting cycle to say the least!

Q: You don’t really speak about shorting ever, have you ever shorted the market or individual stocks? Do you have any advice for those of us who never have?

A: I’m more comfortable waiting during periods of overvaluation and picking up the pieces once the cycle concludes. In other words, I like to profit after prices have declined vs. trying to make money on the way down. Historically I’ve been good at spotting overvaluation, but not so good at timing when bubbles pop. I have put options on the homebuilders that expired in 2006 worthless to prove it!

If I had to be long or short right now, I’d probably be short…and I’d probably be losing money too! Instead of being short and losing money, I prefer waiting in 1-1.5% risk-free yields. Patience is essential in my absolute return process and I view it as a competitive advantage – few are willing to practice near cycle peaks. We’ll see if patience pays this cycle. Historically it has, but there are no guarantees.

Q: Did you read Grantham’s latest piece?

A:    I haven’t read it…and not sure I want to! Who is left? Next thing you know Klarman is going to get fully invested by buying the FANG stocks!

I’m noticing some cost increases in pricing power in Q2 earnings. Inflation isn’t surging, but it’s noticeable. Not sure Fed or the markets are taking anything related to inflation seriously. While I’m not a big user of govt data, I think wage growth in today’s number makes sense…agrees with what I’m noticing. I might be getting desperate and looking for things that aren’t there, but I think labor market pretty tight…ex disciplined value investors!

Q: Speaking of late-cycle grasping at straws, did you see Ackman’s move on ADP?

A: I did not see that on ADP. I don’t follow them, but I can imagine it’s a target given its stable high quality business. I’m not a big fan of activists that buy small positions of a company and make big demands. When activists buy 5-10% positions and then want the company to leverage up the balance sheet…again not a big fan. If you want to buy 51% of the business go ahead…and take as much debt on as you’d like…or whatever other changes you want to make. But if you only own 5-10%, don’t destroy the balance sheet for the rest of us…maybe the majority of shareholders prefer financial strength over financial engineering.

For what it’s worth, I believe activism is one of the many reasons companies have taken on so much debt this cycle. Strong balance sheets are often targeted. ADP’s valuation already rich. Activists running out of companies to bully…or at least stable ones that aren’t already expensive.

Q:  Have you thought about putting together a newsletter with this type of bottom up earnings call transcript analysis in a more consumable format?

A: Yes, I’ve thought about doing something like that…bottom-up macro analysis. However, I continue to remain optimistic that this cycle will end and I’ll be able to manage money again. Time will tell. But I think there’s a market, or need for it. So much of the government data initially appears inaccurate, or the reality is eventually discovered many quarters later…how valuable is information that is eventually revised to look completely different a year from now???

Q: I was wondering if you had a collection of other interviews, previous shareholder letters, etc. that I could read as well.

A: I’ve done other interviews while managing, but most are relatively dated by now. I thought the one below was pretty good but I don’t have a subscription to Wall Street Transcript.

Wall Street Transcript Interview

Q: How is the labor market in Florida?

A: I was offered another job yesterday at my daughter’s softball practice…from a lawncare company. The guy said he couldn’t fill his crews and wanted to know if I wanted to do something to stay busy. If I wasn’t living the minivan dream I’d do it. Interesting times! I think there’s a lot of push and pull going on in labor. Pockets of inflation and deflation, but I’m beginning to lean more towards wage increases. Living in an area that thrives on asset inflation probably pollutes my views (every business here is somehow tied to stocks or real estate). And of course if asset prices ever reverted to fair value all bets are off.

Q: Response to an email discussing pros and cons of relative vs. absolute return investing.

A: I completely understand the dilemma. Be absolute return purist and clients may leave and blow themselves up elsewhere when the cycle ends…or sprinkle in some low tracking error strategies and participate enough to keep clients from bolting at the wrong time. It’s a tough balance and you’re certainly not alone.

It’s funny…I believe most RIAs used my fund not as a core strategy but as an absolute return sliver. I’d guess most RIAs have stock mkt exposure but want some absolute return exposure. Sounds like you are more absolute and want some relative return exposure. Makes sense.

I’m thrilled there are RIAs like you out there that continue to think as a fiduciary. The last thing I’d want to do as an advisor right now is lose 30-50% of my clients’ capital. It won’t be defendable, in my opinion. Not with today’s prices. And while I think those sort of declines aren’t certain, I believe they’re possible based on valuations…at least in the small caps I follow. I can’t really speak outside of my opportunity set, but looks like slim pickings out there for asset allocators. I wish you the best…sounds like you have a very good understanding of the environment.

Q: Did you read Montier interview in today’s Barrons?

A: That was great…thanks for sending! Also cool shirt. On another topic…was at my daughter’s softball practice today and was speaking w another parent who sells windows. He asked what I did for a living and I told him I’m unemployed. He said really, you want to sell or install windows? I said I have no experience in either. He said not a problem as they can’t find anyone with experience and are considering all applicants.

He also told me they just gave a $2/hour raise to all installers and delivery employees. Just out of the blue. Said they’re trying to get in front of any turnover. I know just one data point but wouldn’t it be interesting if labor costs go up +3-4%…and trending up so the term “transitory” couldn’t be used. So much riding on belief Fed will QE again on next decline in asset prices (a sharp decline won’t be allowed or will be temporary).

What if they can’t QE during the next decline…inflation wouldn’t allow it? I’d like to see higher rates. It would put valuation mean reversion and financial justice on the fast track! One can only dream…

Q: Just returned from a business trip to London – if inflation is moderating why was everything so expensive?

A: It’s a good point about London. Everyone talks about deflation in Japan but it’s one of the most expensive places to live in the world, especially cities like Tokyo. How does that make sense?

Would You Rather

Last week I reviewed the investment options in my kids’ 529 plan. Slim pickings was the easy conclusion. Similar to many 401k plans, 529 plans are typically filled with index or index hugging funds, with few if any absolute return options. Instead of investing in a stock or bond fund with impressive historical returns, I decided on the lowest return option – cash equivalents.

In addition to limited investment alternatives, low interest rates and high equity valuations make contributing to a 529 plan today unappealing to me. In my opinion, it’s a good example of how low interest rates and inadequate future returns can discourage saving.

I was fortunate to grow up during a period of high interest rates. I was also fortunate to have a grandfather who understood the power of compounding. When I was born, my grandfather bought high-yielding CDs and set them aside for my education. Thanks to his sacrifice, along with Paul Volcker’s prudent and persistent monetary policies, the CDs compounded nicely and eventually funded a large portion of my college education.

I attended Stetson University in Deland, Florida. My grandfather didn’t call it college, but jokingly referred to it as “fun in the sun”. While I studied and made good grades, he was right, I was also having fun. I thoroughly enjoyed college. The independence, hanging out with friends, and even learning – it was as good if not better than the brochure advertised.

In addition to learning and having fun, my friends and I participated in spirited intellectual discussion and debate. One of my favorite debate forums took place while playing the game Would You Rather. Topics varied considerably and included important questions such as, “For $10 million, would you rather have a giant beach ball or bowling ball permanently attached to your left hand?” Or my personal favorite, “If required to do so, would you rather have ‘Hot Shots’ or ‘Say It Aint So’ tattooed on your forehead?” That was a tough one!

I was reminded of the game Would You Rather last week as I was catching up on quarterly reports and conference calls. As readers may recall, last quarter I noted and documented several examples of companies reporting rising costs and pricing power. Early indications suggest this trend is continuing in the third quarter.

While several companies I follow are reporting higher costs, government inflation and wage data remains subdued. As the dispersion between rising costs and reported inflation becomes more apparent to me, I can’t help but ask, “Would you rather rely on economic data gathered from operating businesses or government agencies?”

Of course, most economists and policy makers rely on government data to form their macro opinions. As such, it’s not surprising many central bankers are currently more concerned about inflation being too low than they are about inflation accelerating. In fact, on Monday, Charles Evans of the Chicago Federal Reserve said he was nervous low inflation might be structural, not temporary.

After reading Mr. Evans’ comments, I immediately thought of a cure for his low inflation anxiety. Specifically, I suggest he start a business and attempt to hire 100 qualified and skilled employees, such as welders, truck drivers, nurses, installers, painters, electricians, machinists, and construction workers. And try offering these skilled workers and potential employees an industry wage to join your company. Good luck!

In addition to rising labor costs, there were other examples of rising costs in recent quarterly reports and conference calls. Kroger (KR) recently made a very interesting comment on food inflation. Management noted, “…we had overall product cost inflation for the first time since 2015.” And, “Cost inflation trends for the second quarter were consistent by department with grocery, liquor, produce and meat all positive for the quarter. Deli was deflationary and pharmacy continues to be inflationary.” Food was one of the few areas where I was noticing declining costs over the past several quarters. That trend appears to have reversed.

Casey’s General Stores (CASY) reported noticeable wage inflation in its recent quarter, stating, “…store level operating expenses for open stores…were up approximately 3.9% in the first quarter, which includes our decision back in December to keep our commitment to salary increases for our store managers, stemming from the proposed change by the Department of Labor to increase the minimum salary for exempt employees.”

Lowe’s (LOW) recently reported comp sales of 4.5% with 0.9% coming from higher transactions, while 3.6% from an increase in average ticket. Management noted “job and income gains should continue to drive disposable income growth, and favorable revolving credit usage continues to hover near the highest rates of the current economic expansion, supplementing the spending power generated by stronger incomes.” The company also expects home price appreciation, or asset inflation, to persist.

And finally, Target (TGT) announced early this week that it was raising its minimum wage to $11/hour next month and to $15/hour by 2020. Management believes the increase is necessary to help attract new employees and keep existing employees – another clear sign of wage inflation.

While I’m curious if upcoming inflation reports will eventually reflect the higher costs and pricing I’m noticing, my investment process does not rely on government data. Instead, I use the operating results of the hundreds of businesses I follow to form a bottom-up macro and profit cycle opinion.

As Q3 earnings season approaches, I plan to pay very close attention to information related to corporate costs and pricing. As several Fed members communicate their concerns regarding inadequate inflation, I believe costs and pricing power may actually be accelerating. If so, investors relying on historically low interest rates to justify current equity valuations may need to reconsider their inflation sources and assumptions. In fact, while it’s difficult to predict the exact catalyst that ends the current market cycle (and sometimes a catalyst isn’t needed), I would put an unexpected increase in inflation and interest rates near the top of my list.

Conversation With Preston and Stig

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

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

Podcast:  Conversation With Preston and Stig

It’s Not You, It’s Me

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Role-Play Screening

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

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

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

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

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

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

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

Bottom-Up Economics

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

What’s Happenin’

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

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

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

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

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

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

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

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

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

Counting Boxes

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

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

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

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

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

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

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

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

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

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

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

The Third Time is the Charm

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Have a great weekend!

 

Coin Flip Investing

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

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

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

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

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

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

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

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

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

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

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

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

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