The Mullet Discount

I’m often asked if I meet with management of the companies I analyze. I typically do not. Given the large number of stocks I follow (300 name possible buy list), traveling the country visiting corporate headquarters simply isn’t practical. However, I will call management when I have questions. My questions are usually relatively simple and are meant to help me better understand the company’s profit cycle.

While I’m sure one-on-one meetings with management has its benefits, there are risks as well. CEOs in particular can be very charismatic people. Many are simply enjoyable to be around and are likable. It’s often a reason they made it to the top of their organization, especially if the business has a strong emphasis on sales and marketing.

I’ve also found when I spend the time and money visiting a company, I’m more inclined to want to recommend the stock. In other words, the higher the sunk costs on an investment idea, the higher the risk decision making is influenced. This is a risk analysts should be aware of even without visiting a company. It’s harder to say no to an investment idea you’ve worked on for several weeks versus a few hours.

Early in my career when my possible buy list was much smaller and I was encouraged to travel, I met with CEOs and management teams more frequently. I was working in New York, which provided me with access to many management teams. During my first few meetings as a buy-side analyst, I remember being a little uncomfortable. I was only 25 years old and was asking experienced and accomplished CEOs questions that often challenged their corporate pitch. And as young analysts often do, I sometimes asked some really stupid and inappropriate questions.

I remember having lunch with the founders of a chain of Papa John’s restaurants. They had accumulated a large number of franchise stores and were going public. I’ll never forget it. We were just seated for lunch and I found myself sitting next to the CEO. Here was my chance to prove I had what it took to be a world-class equity analyst. But no, it wasn’t to be. I had to open my mouth and ask a completely irrelevant and idiotic question.

As a consumer of Papa John’s pizza, I was always curious about the nutrition content of the giant tub of butter they distribute with each pizza. As an analyst trying to prove himself in front of his peers, one of my first questions of a real live CEO was, “So how many grams of cholesterol are in that tub of butter?” I immediately knew it was a stupid question. The CEO didn’t even respond. Instead, he gave me this look that said, “Who let this punk kid in here? And why is he sitting next to me?” I didn’t say another word and left after finishing my complimentary and delicious decaf (side note: Roadshows have the best coffee! Coincidence or does Wall Street really want us wired so we make rash decisions?).

Although I eventually learned to ask more appropriate questions, I continued to find a way to stick my foot in my mouth. I remember a CEO giving me an energetic pitch on their company’s growth plans. It was as if he was reading me a script from an infomercial. I’m not sure exactly why, but I felt comfortable pointing out the obvious. So I looked at him with a smile and said with a friendly tone, “You’re so full of $#^@.” Fortunately, instead of punching me, we both had a good laugh. I was a little embarrassed by my abrupt comment, but he was full of $^#% and we both knew it. Once it was out in the open, we were able to have a very productive conversation.

There’s nothing wrong with promotional CEOs, as long as you know you’re being sold. Some of the best companies are managed by successful salespeople. Their business and industry may require it. Furthermore, properly communicating a business strategy is an essential role of the CEO. The more educated investors become, the more comfortable they will be allocating capital to the business. Companies with an attractive cost of capital have competitive advantages. In addition to higher equity compensation for employees, a high valuation and low cost of capital benefits a company’s merger and acquisition strategy (not to mention avoiding being acquired). Furthermore, companies with lower cost of capital typically have more financial flexibility and are considered lower risk business partners.

One of the things I really like about following and analyzing a relatively fixed opportunity set, is over time I get a good feel for the management teams of each business. Who are the charismatic promoters, who are the detailed accountants, and who are the book-smart engineers? They’re all different and require different analytical filters. It’s our job as analysts and investors to sort out management personalities and adjust our valuation assumptions accordingly. It’s also important to know your biases. You may like the promoter, or you may like the boring no-nonsense CEO. We all have our favorites, so we need to be careful applying discounts and premiums to management teams based on likability instead of capability.

Speaking of investor biases, several years ago there was a company that I really liked, but seemed to be out of favor with investors. It was a great business with a strong balance sheet and consistent free cash flow. When I started my research I couldn’t understand why the business was selling at such a large discount to my calculated valuation. What was I missing? I had a theory. The CEO had a very noticeable and thick Southern accent. When he said “percent” it sounded like “purrrrCENT”. You can imagine how many times a CEO says “percent” on a long conference call. To this day, I believe investors were applying a Southern drawl discount to their stock. Considering I grew up in Kentucky and proudly sported a mullet throughout most of my wonder years, I didn’t apply a similar discount. In fact, given the high-quality nature of the business, I applied a premium (lower required rate of return). Eventually its valuation gap closed, making it one of my larger winners on a purrrCENTage basis. In conclusion, while investor management biases can be a risk, they can also lead to opportunity!

Do Something Do Nothing

There are many things absolute return investors have in common. For instance, most absolute return investors prefer avoiding crowds, as crowds and value rarely coexist. Theme parks are a good example. Have you been to Disney lately? Along with the crowds and long lines, you’ll find high and rising prices. In fact, according to Bloomberg, Disney recently announced it was raising park prices 1.9% to 4.9%.

As a dedicated contrarian and absolute return investor, I prefer Legoland over Disney. At Legoland you will find fewer crowds, shorter lines, and lower prices. In my opinion, it’s simply a better value relative to risk assumed. We’ve been several times and went again last week for spring break.

During our visit I didn’t spend much time monitoring the markets. However, out of curiosity, on Thursday I decided to break away from the rides to take a glance. I should have stayed on the roller coasters! Investors appeared confused. Should they buy stocks in anticipation of the reliable quarter-end entitlement rally or should they sell stocks as Trump euphoria shows signs of fatigue?

It is times like these that I’m very grateful I’m not required to be fully invested in inflated assets. With my absolute return portfolio currently positioned 100% in patience, I’m not very concerned about the near-term direction of the stock market. It can spike higher or it can crash. To accomplish my absolute return objective, the exact heights equity prices reach this cycle is irrelevant. It will be the prices I ultimately pay when I allocate capital that will determine my future returns.

While I’m comfortable ignoring the markets and remaining patient for an extended period, I admit I’d prefer being fully invested in wonderful businesses selling at attractive valuations. Unfortunately, owning a portfolio of high-quality small cap businesses at today’s prices is off limits. My process and discipline is very clear about this – overpaying is not an option. Therefore, while I prefer being invested, during periods of rotating bubbles and broadly dispersed asset inflation, large allocations to patience, or cash, is often necessary.

Relative return investors view patience and cash differently. Regardless of valuations, most relative return investors remain fully invested throughout the entire market cycle. As an absolute return investor, this has never made sense to me. Think of all of the rules of successful investing, such as: buy low sell high, don’t lose money, or be fearful when others are greedy and greedy when others are fearful. What do all of these rules require? Patience. And how can investors be patient without the ability and willingness to hold cash?

With equity prices and valuations near or at all-time highs, instead of selling high, avoiding losing money, or being fearful, most active managers appear to be all-in with mutual fund cash levels near record lows (approx. 3%). While many of our investment heroes preach the importance of being patient and selective, when I open the hood of many actively managed funds, I see signs of “full throttle” late-cycle investing.

It’s understandable. In extended bull markets, the pressure and urge to do something and keep up with the herd can be overwhelming, while the rewards of being patient and doing nothing appear nonexistent. But doing nothing is exactly what I believe is required during periods of inflated asset prices. Why force invest in inflated assets if you don’t have to?

Unfortunately, many portfolio managers feel that they don’t have a choice and must remain fully committed. To some extent, this is true. Due to investment mandates requiring managers to be fully invested, a portfolio manager’s view on valuations, opportunity sets, and future returns may be irrelevant when determining the amount of cash a manger holds.

The growth in passive investing has also placed increasing pressure on managers to keep up during market cycle booms. Passive funds are aggressive competitors that do not care about valuation, do not hold cash, and are incapable of practicing patience.

I’m sympathetic to the position relative return investors find themselves in at this stage of the market cycle. Although many professional investors may be well aware that their opportunity sets are expensive, career risks often override investment risk concerns (thanks to a reader for sending the following article on career risk: link.) Jeremy Grantham (the leading expert on career risk) writes, “The central truth of the investment business is that investment behavior is driven by career risk.” In effect, for many professional managers, looking different is simply too risky from a business and asset under management (AUM) perspective.

I often wonder if the modern-day goal of risk management is to monitor the risk of losing assets under management instead of the risk of incurring losses on client capital. I’ll never forget being told after a good year of performance and bad year of asset under management growth, “Eric, you can make the best dog food in the world, but if the dog won’t eat it, it doesn’t matter.”

Regardless of the business challenges associated with absolute return investing, I’ve spent most of my career committed to maintaining the flexibility to hold cash and avoid overpaying. My absolute return objective attempts to protect capital during periods of inflated asset prices and act opportunistically when being adequately paid to assume risk. To achieve this objective, holding a large cash weight during certain portions of the market cycle has been required.

There are times when my process and discipline has been labeled a broken clock. Whether intended to be or not, I view this as constructive criticism and an important reminder of how absolute investors should not be positioned. Given cash is an awful long-term investment, I believe it’s important to avoid remaining patient throughout an entire market cycle. There should be a period during each market cycle when investors are being adequately paid to assume risk. In other words, during every market cycle, there is a time to be patient and a time to be opportunistic. Full-cycle broken clock investing should be avoided, while flexibility and decisiveness should be embraced.

Lastly, I want to make clear that my patient positioning is not an attempt to time the market. Instead, portfolio positioning is a direct reflection of the number of stocks within my universe of high quality small-cap business that pass my absolute return hurdle rates. It’s also important to be aware that holding cash can result in significant opportunity cost. However, during periods of excessive overvaluation, I believe opportunity cost is preferable to overpaying and risking substantial losses to capital. Furthermore, I’ve found opportunity cost can be quickly recovered once market cycles conclude and prices adjust. Conversely, significant losses resulting from overpaying can be much more difficult to recover from and can even be permanent.

In conclusion, I continue to prepare for the future as current prices and valuations do not interest me. As has been the case in past cycles, I expect equity valuations will ultimately normalize, causing price dislocations and sufficient opportunity. Although my patient positioning may cause my absolute return portfolio to lag the markets, I believe it is essential in achieving my objective of generating attractive absolute returns over a full market cycle. Patience and cash allows me to limit mistakes during periods of overvaluation and act decisively (without selling existing holdings) when opportunities return. While cash can be extremely boring during market manias and relentless bull markets, allocating it when prices plummet and the bids disappear can be extremely rewarding. I can’t wait! On second thought, I think I can and I think I will.

Perception Risk

A friend emailed me a Bloomberg article last week regarding the next “big short” in retail-backed mortgage securities. The article stated, “Wall Street speculators are zeroing in on the next U.S. credit crisis: the mall.” It was a good article and flowed as I expected. In effect, retailing is in trouble, malls are in trouble, so short retail-backed mortgages. Although it makes sense to me, successful shorting is not on my list of career accomplishments. I have a pretty good record of spotting overvaluation and asset bubbles, but accurately predicting the tides of investor sensibility continues to elude me. As I’ve mentioned in past posts, instead of looking for trouble by shorting overvaluation, I prefer avoiding it and taking advantage of the inevitable bust.

As the Federal Reserve increases the fed funds rate and communicates further rate increases are on the way, I’ve been collecting an increasing amount of evidence suggesting many consumer-related businesses continue to struggle. It’s a trend I noticed and documented last year. In October I wrote, “If my theory on a weakening consumer holds, I believe more consumer discretionary businesses will report challenging operating results in Q3. If I was forced to play the game and had to be invested, I’d be extra careful owning seemingly inexpensive consumer discretionary companies with questionable balance sheets. There are no free lunches at this stage of the market cycle. If it looks cheap, it’s most likely cheap for a reason. There are thousands of desperate investors currently scavenging for any crumb of value they can find.”

The weakness I noticed in Q3 2016 was not a one quarter occurrence, as many consumer companies continue to report weak sales comparisons and traffic trends. Last week I listened to several consumer company conference calls including, Stein Mart (SMRT), DSW Inc. (DSW), and Casey’s General Stores (CASY). All reported challenging operating environments.

Stein Mart (SMRT) reported comparable-store sales decreased -5.5%. For the year, same-store sales declined -3.8% due to a “decline in transactions, which was driven by traffic.” Stein-Mart appears to be taking a page out of Kohl’s (KSS) playbook, by reducing inventory and promotions, with Stein-Mart’s average inventory per store declining -5.9%. Inventory per store is expected to decline again in 2017. Management noted on their conference call, “Having less inventories will certainly give us that much less to clear at the end of season.” While fewer markdowns and promotions may help gross margins in the near-term, I doubt lower inventory and higher prices will help declining traffic.

DSW Inc. (DSW) generated similar results with comparable sales declining -7%. DSW is also reducing inventory in an attempt to enhance margins. Gross margins increased 0.5% in the quarter, while inventory per square foot decreased -8%. It will be interesting to see how long the increasingly popular strategy of reducing inventory and promotions can be maintained. In theory, it can’t continue indefinitely as eventually there won’t be enough inventory to sell. In fact, it could be a good time to buy a suit and pair of shoes. With inventory declining in the high single-digits, not only will discounting be less likely, you may have trouble finding your size! I believe the trend towards lower inventory also supports the investment thesis of shorting retail-backed mortgages. Less inventory = too much retail space = more store closures = stress on retail-related mortgages.

Casey’s General Stores (CASY) reported same-store sales increased 3%. While positive, results were less than the company’s annual goal. Management noted Casey’s suffered from many of the same factors influencing results of other convenience and grocery stores. Management also stated the consumer seems anxious with uncertainties, such as healthcare, weighing on confidence. While discussing costs, management pointed out higher wages and payroll taxes. Price increases in certain items, such as coffee and pizza, were also mentioned. And finally, the consumer’s move to cigarette packs from cartons was discussed again this quarter, along with the shift to generics from branded (another sign of consumer stress).

The dispersion between the results of consumer discretionary businesses and elevated consumer confidence is interesting. It’s a strange environment. The economy is not in recession and the stock market is soaring (confidence high), yet operating results indicate growing consumer uncertainty. What is an absolute return investor to do?

My plan is to continue to adjust for consumer uncertainty through the use of cash flow normalization and scenario analysis. While some are more stable than others, in my opinion, most consumer companies are cyclical and should be valued accordingly. I believe it is particularly important to account for trough cash flows expected in the next recession and bear market.

It’s been a long time since investors experienced a recession or bear market. That said, there have been significant downturns in specific sectors. The most recent being in commodities (2014-2016). The bear market in commodity stocks is fresh in my mind as I bought several during this difficult period. I remember how investor psychology shifted from adoring commodity stocks in the early stages of the current market cycle, to despising them during its later stages.

During the bear market in commodity stocks, I focused on precious metal miners with strong balance sheets. Although valuations were very attractive, investor sentiment was extremely negative. Given the negative perception associated with owning the miners, it was difficult for many asset managers to purchase. It was simply too uncomfortable and embarrassing. To hold the miners, a portfolio manager needed to incur considerable perception risk.

In my opinion, perception risk is one of the most underappreciated risks professional investors encounter. Regardless of valuation, when a stock or sector is significantly out of favor, it can carry too much career and AUM risk to include in a portfolio. Even if a portfolio manager wants to own a specific investment, if it carries too much perception risk, it may be avoided in favor of a security that is deemed more acceptable by peers and clients.

I’ve often wondered if there is an unofficial security approval list circulating within the asset management industry. Stocks on the list may be pricey, but they’re comfortable to own and perceived to be good businesses. I’m sure you can think of a few off the top of your head (if not, try pulling up the top holdings of most popular benchmarks). Stocks not on the list may be attractively priced, but are perceived to be too risky or contrarian to hold.

With investors considering retail-backed mortgage securities as the next “big short” and the S&P Retail ETF down -2.5% YTD, negative sentiment in consumer discretionary stocks is building. Will consumer stocks, such as retailers, eventually be removed from the asset management’s approval list and be off limits to managers overly concerned about career risk and tracking error? Will certain consumer stocks become too embarrassing for professional investors to own? I certainly hope so. As an investor long liquidity and patience, I’d be thrilled to be able to take advantage of another sector bear market amplified by perception risk.

Bloomberg Survival Guide

It’s been several months since Bloomberg pulled the plug. After having access for 23 years, it was a tough breakup, but I survived. I want to thank everyone who helped by sending links and alternatives — especially the free ones! A friend sent me a new one today that I thought I’d pass on. It’s called QuickFS (link). It’s great for screens and a quick financial overview. If you have sites that can help those of us without big hedge fund incomes and Bloombergs, please send my way. If I get enough of them, I’ll put a list together and post.

Due to a busy schedule I’ve been unable to post this week. Unemployment has been considerably more hectic than I expected! I should be back next week. There’s a lot to discuss.

Have a great weekend!

 

Wall Street Price Targets

While researching a company today, I bumped into a chart that included the stock price and the average Wall Street price target (chart below). It provided me with a good early morning chuckle. I’m sure most of you have seen similar charts and have noticed the same thing. Specifically, Wall Street price targets are often highly correlated to stock prices. If a stock goes up, the price target goes up. If a stock goes down, the price target goes down. Tell me the price of a stock and I’ll tell you what Wall Street believes the company is worth.  It’s a very reactive valuation process, and in my opinion, not a very accurate one. It’s one of the many reasons I avoid sell-side research.

The company in the chart above missed Wall Street’s earnings estimate last quarter. Shortly after the stock declined, Wall Street analysts adjusted their earnings models and lowered their price targets. Reactive target adjustments such as these are made frequently on the upside and downside.

In my opinion, the reason Wall Street price targets are so volatile is due to their valuation methodology. Most Wall Street analysts use an earnings multiple, such as P/E or EV/EBITDA, and apply this multiple to their earnings estimate for next year. For example, an analyst may value Company XYZ at 20x its 2017 earnings estimate. Simple enough, right? Right. But here’s the problem. By using next year’s earnings as the foundation of a business’s valuation, one year of profit is being used to value a perpetual asset with many years of uncertain profits.

Operating results and profits change from one year to the next. Sometimes earnings volatility is structural, while other times it’s simply a natural part of a company’s profit cycle. For example, the company in the chart above is experiencing a near-term decline in revenues and earnings. Such fluctuations in the company’s operating results have happened in the past and should be expected in the future. Over time, revenue growth and margins have evened out, with the company reporting some good years and some bad. Instead of taking normal fluctuations in operating trends into consideration, analysts that value businesses on near-term earnings are often more concerned about what is happening now versus what will happen over an entire profit cycle.

By properly accounting for the natural volatility in revenues, expenses, and other variables that influence full-cycle profits, I believe investors can produce a more accurate and less volatile business valuation. Unlike their underlying stocks, the value of most established operating businesses are relatively stable and change infrequently. In theory, intrinsic values should grow as profits and free cash flows are reinvested into the business. Business values can also change due to shifts in organic growth and improvements in the balance sheet. However, for mature businesses, these trends are typically gradual and should not change noticeably from one quarter to the next.

Below is an example of a chart I’d expect to see with a high-quality business over a two-year period. While its stock fluctuates with the market and company-specific news, the value of the business is stable and grows gradually. It’s quite a bit different than the average analyst price target chart above, isn’t it?

In conclusion, operating results and margins can and do fluctuate over a profit cycle. By considering these fluctuations in advance through the use of profit normalization, I believe investors can improve the stability and accuracy of their business valuations. A more stable and accurate valuation provides many advantages including a higher batting average (winners vs. losers), lower turnover, an increase in valuation confidence, and improved decisiveness. Moreover, normalizing just makes sense, doesn’t it? I think so. And that’s my goal when determining a business’s value. I want to value a business in a manner that makes the most sense to me, not Wall Street.

Managing Mistakes

A reader recently asked me to talk about my sell discipline and past mistakes. It’s a good subject so I thought I’d do a quick post.

As I’ve stated many times, limiting mistakes is very important for absolute return investors. While we can’t eliminate them, I believe mistakes can be minimized by following some basic guidelines. Rules that have helped me limit mistakes include: refuse to overpay; understand and normalize profit cycles; use realistic valuation assumptions; avoid businesses that can’t be valued (i.e. unpredictable cash flows or unmeasurable liabilities); separate operating and financial risk; ignore benchmarks and peers; embrace patience; and finally, focus on established businesses with sufficient operating histories (necessary for accurate valuations).

While I believe these guidelines have improved my batting average considerably, I have and will continue to make mistakes. One of my favorite presentation slides listed all of my winners and losers since 1998 (defined as realized gains and losses). It was an interesting and unique slide, as it included every mistake I’ve made over the past 18 years. Fortunately all of my losers (highlighted in red) fit in one column. I found this slide very useful when communicating with clients and potential clients. A popular question or request for portfolio managers is, “Tell me about a mistake you made and what you learned from it.” I’d respond, “Turn to page 18. They’re all there. Which one would you like to discuss?” Wouldn’t this be an informative slide for all active managers?

One of my first and largest mistakes of my career was The York Group (YRKG). If my memory serves me correctly, it was a -50% realized loss. It was a meaningful loss on a full position and it hit me when I was already having a tough year (1999).

The York Group was a market-leading manufacturer of caskets, behind Hillenbrand. When I bought their stock it appeared to be the perfect stable business and industry – death care. How could I mess this one up? While growth was slow, revenues and cash flows were very predictable. Assuming you could get over the uncomfortable nature of the business, the death care industry had many attractive attributes of a high quality business. And Wall Street seemed to agree.

In the mid-90s, Wall Street was busy helping the market-leading death care companies (mainly funeral homes) consolidate. Wall Street was racking up investment banking fees and placed strong buy recommendations on almost every death care stock. Death care quickly went from a pile of boring low-growth private businesses to an exciting publicly traded growth industry! However, in the end, it was just another roll-up scheme that ultimately ended badly for many of the funeral home consolidators and investors.

I wanted to learn more about the industry, so I decided to attend one of the death care conferences in New York. I’ve never been to an investor conference quite like it. This was a group of companies rooting for a bad flu season. It was strange and a little uneasy, but ultimately I accepted that these were simply businesses providing society with necessary products and services.

I eventually became quite knowledgeable of many of the companies in the industry. After getting to know the industry better, I decided I didn’t want to own the funeral homes. They were expensive and I’d been investing long enough to know the risks associated with roll-ups and aggressive acquirers. Instead of buying the funeral homes and cemeteries, I focused on the companies that sold to them, like the York Group and Mathews International (caskets and bronze memorial plates).

So how did I lose money on what appeared to be a relatively low risk investment? To put it simply, things went wrong. First, the company lost a large contract to its largest competitor, Hillenbrand. While I knew this was a risk, I didn’t properly discount for the revenue concentration and contract risk (I should have used a higher discount rate in my valuation model). Furthermore, the negative operating leverage from the lost contract was greater than I expected (I should have used a lower worse case cash flow assumption in my scenario analysis).

In addition to the drop in revenues and earnings, the lost contract caused management to panic. To replace the lost revenues, York made a large acquisition of a bronze plate manufacturer.  The company took on debt and paid a healthy price. To make the acquisition work and improve profitability, management consolidated the bronze plate manufacturing facilities. The strategy backfired and caused bottlenecks and delivery issues. To make matters worse, York’s balance sheet was now leveraged with debt from the acquisition, limiting their financial flexibility.

My “sure thing” low-risk investment quickly transformed into a large unrealized loss with operating risk and financial risk. And this is when my sell discipline kicked in. When I purchased The York Group they had a strong balance sheet (low debt to cash flow) and low operating risk (very consistent business). After I purchased their stock, they eventually took on both forms of risk.

I’m comfortable assuming financial risk or operating risk, but never both. When investors assume both forms of risk, the probability of a business operating under distress or the threat of bankruptcy is elevated (leveraged energy stocks in 2015-2016 are great examples). As an absolute return investor, I never want to position myself to have a stock go to zero. Stocks can recover from a lot of things, but zero is not one of them. Avoiding and selling businesses with operating and financial risk has allowed me to keep goose eggs off the scoreboard and limit large losses.

Another reason I’ll sell is if I feel I can no longer value the business accurately. If something occurs while I own the business that creates too much uncertainty in cash flows, assets, or liabilities, I will sell the stock.

Lastly, I will sell a stock when it trades above my valuation and I’m no longer being adequately paid to assume risk. Fortunately, this has been the reason for most of my sells over the past 18 years.

Before I conclude, I want to touch briefly on averaging down on positions with unrealized losses. I will average down assuming I remain confident in my valuation AND my valuation is stable. If my valuation is in decline, I will not add to the position. If I’m forced to reduce the valuation of a business, I clearly got something wrong. Either my discount rate was too low or my cash flow and growth rates were too high. To protect myself from myself, I like to wait for my valuation to stabilize before adding to a position (I update my valuations quarterly).  I don’t want to be stubborn and buy a company all the way to zero (I call it pulling an Enron). My valuation in decline rule, helps me avoid emotional buying driven by my ego (yes, we all have them and they can be very dangerous!).

I hope my sell discipline and guidelines help you think of ways to reduce meaningful losses and mistakes. What’s that famous Buffett quote? Rule #1 don’t lose money. Rule #2, don’t forget rule #1. I really like that one as it fits the absolute return mindset perfectly!

I’m looking forward to the end of the current market cycle when we discover who has been following all of the rules of successful investing. During periods of inflated asset prices and extended market cycles, rules on minimizing mistakes aren’t very popular. Thanks to the reader for requesting and reminding me of its importance.

For Wage Inflation Press 1

I enrolled in graduate school during the tech bubble. With the Nasdaq up over 80% in 1999 and the portfolio I was managing down -8%, my career in investing appeared to be over. As such, I thought I might as well go back to school and try to figure out what I was going to do next. As luck would have it, shortly after I enrolled, the tech bubble popped and I kept my job! I wasn’t thrilled about going back to school while working, but in hindsight I’m thankful Greenspan’s “New Economy” forced me into getting my MBA.

While I had some very good classes, one of the things I remember most was all of the new terminology I acquired. Some examples include: mission critical, thought leader, paradigm shift, scalability, footprint, SWOT, and [insert anything] followed by solutions. It’s all about those solutions!

Although “sound smart” business terminology isn’t very useful in investing, it can be helpful when translating business lingo. For example, Sykes Enterprises (SYKE) is a market leading provider of comprehensive customer contract management solutions in the business process outsourcing industry. Sounds impressive, but what in the world do they do? MBA translation: operator of call centers.

Sykes is on my possible buy list, along with its competitor Convergys (CVG). The call center industry is a pretty boring business, but the market leaders can generate attractive free cash flow. Operating margins average around 8-10%. Margins fluctuate with capacity utilization and changes to client programs (new products, marketing, decision to take call centers in-house or outsource, etc). Industry growth is similar to nominal GDP (around 3%). The market leaders have benefited from their clients’ desire to consolidate service providers. Automation and technology present risks and opportunities. In my opinion, the call centers are not great, but good businesses (assuming you’re a market leader).

I’ve owned Sykes and Convergys in the past. With the stock of Convergys in decline and becoming more attractively priced, I’m currently getting up to speed on both companies. As I worked on their businesses this week, I bumped into something I’m noticing more frequently in recent earnings reports and conference calls – inflation. Specifically, Sykes and Convergys both mentioned growing wage pressures within their industry.

Sykes did a particularly good job of explaining rising labor costs on their conference call. Their CEO, Charles (Chuck) Sykes, has historically gone out of his way to help investors understand the industry and operating environment. His commentary is usually long, but often very worthwhile. I selected and highlighted several of his comments related to labor costs.

Sykes is noticing wage inflation in local markets and is having to spend more to engage employees.

“Given the headline improvement in employment trends in the US, where the unemployment rate has been hovering around 4.8%, there is some concern about limited slack in the labor market and wage pressures, although there have been pockets of labor tightness in some cities and states, the broader picture across the markets in which we operate remains manageable. Still with labor slack dictated more by local market conditions, we are having to employ monetary and non-monetary levers to optimize employee engagement. Specifically we are adjusting strategies and tactics around talent management with a focus on improving attrition and absenteeism.”

Wage inflation remains manageable, but if it tightens further, more will need to be done.

“All told, the supply of labor doesn’t appear to have reached that tipping point where it is impacting our long-term margin targets but if the economy picks up steam rapidly and as a broad spectrum of industries use wages to access labor markets, we will have to work with our clients to help them evaluate the best trade-offs between wage and price against our service strategies.

Discovering and monitoring wage inflation is a process – there’s not an immediate notification.

“To answer your question, you know, it took us a little bit to really start suspecting things around the wages. I mean normally, and I think this is probably true for most anyone in our industry, you know, the symptoms are looking at your application rates. You know, a number of people that are showing up at your door to want to get a job and you start looking at your recruiting or once you hire the folks, a number of people that show up or once they show up, the number of people that, you know, what the absenteeism rate is and then once times going on, you know what that attrition level is. These are normal drivers that have been around for many, many years but normally when you start suffering in one of those, candidly I would say most of the time it’s kind of operationally driven.”

Initially management thought labor pressures were a result of normal fluctuations in business activity, but eventually concluded it may be something more.

“But once we worked on this for a while during the ramps and we just weren’t moving the needles enough and then just all the commentary that we’re all reading in the papers about minimum wage pressures. Keep in mind now, you know, we’ve had 22 states in our country that have raised minimum wage. You know, as we look at those things, those are things that we’re starting to avalanche our head and say I think maybe we’ve got some challenges here on the wage side.

Sykes is early in the process of addressing labor challenges, but they plan to move ahead – other clients and industries have already announced wage increases.

“Again, what’s encouraging is I believe this is something that in the beginning it’s going to be a little tight because I don’t know if our competitors are all moving at the same time that we are. I would say probably not. That’s going to create a bit of unevenness, if you will, and maybe when you’re chatting with other colleagues of ours, our competitors, how they speak about it. But I do think we are starting to see, we’ve already seen some of our big clients, particularly in banking industries, they on their own have announced wage increases. I believe it’s real and I believe the industry will adjust.

How quickly the labor cost trend increases remains uncertain.

“The challenging news is I just don’t know how fast. And again for our group of customers and conversations we’re having, we’re anticipating more of the second half of the year to get some of those things resolved. It’s a long answer to your question but it’s a complicated thing in just trying to give total context to it.”

Thank you Sykes for the very informative and productive discussion on labor inflation. As the Federal Reserve debates whether to raise the fed funds rate 25 basis points to 0.75%, the real world isn’t waiting around to respond to the changing price and cost environment. For Fed members voicing their concerns about falling behind the inflation curve, it might be time to call their favorite customer service center and start measuring wait times! Your call is very important to us…

Have a great weekend!

Strong Buy: Nike Men’s 11 ½

A college friend of mine has an incredible memory. While in college, instead of using his talent to make stellar grades, he memorized movie scenes, comedian acts, and whatever else he found entertaining. In addition to having a great memory, he was, and still is, very good at delivering what he memorizes – it’s often better than the real show!

I recently had lunch with my friend. It’s always an enjoyable and easy lunch. All you need to do is sit back and wait for him to start entertaining. During our last lunch, he asked if I’ve ever seen the comedian Louis CK perform. “I have not,” I said. He seemed to be excited. “Oh, he’s great, you’re going to love this.” He immediately started into his Louis CK performance.

The short and clean version (profanity-filled version google Louis CK Bill Gates):

“I was reading about Bill Gates…he has like $85 billion.”

“Do you know what you could do with $85 billion? You could buy every baseball team and make them wear dresses, for like $3 billion and still have $82 billion…how do you not do that!? I would do s&%# like that every day.”

“One day I’d go out and buy all the pants in the world and just burn them. #*&% everybody. No more pants. Start over with making pants. They’re all gone.”

As my friend continued with his show, my mind unexpectedly shifted to the consumer. Louis CK’s idea of buying all of the pants reminded me of Kohl’s (KSS) recent quarterly report and its vanishing inventory. Kohl’s recently announced quarterly same-store comps of -2.2%. Comps probably would have been worse without a 3.7% increase in average price at retail. Transactions per store declined a whopping -6%.

In a sluggish consumer environment with declining traffic, retailers and restaurants seem to be taking two very different approaches. They’re either discounting in an attempt to improve traffic, or increasing price and reducing promotions to protect margins. Kohl’s appears to be protecting margins. This can be seen in their gross margins and inventory. Despite declining same-store comps, gross margins increased 33 basis points during the quarter as they “improved both permanent and promotional markdowns.” Management also noted inventories by year-end declined 5% in dollars and 7% in units (disappearing pants!).

What do lower promotions and lower inventory mean for consumers? Higher prices of course. Increasing signs of inflation is a theme I’ve noticed over the past few months and a trend I continue to monitor closely. Even the government seems to be picking up on higher prices. Today the Commerce Department reported the personal consumption expenditure price index rose 0.4% in January and is now up 1.9% year over year. With the fed funds rate remaining well below the rate of inflation, it’s rational to question the Federal Reserve’s commitment to containing the recent uptick in consumer prices.

With the Federal Reserve falling behind the curve, how can consumers protect themselves from the rising cost of living? If hard assets aren’t your thing, what about taking advice from Louis CK and “buying all of the pants”? The concept of making money from inventory isn’t new. For example, Core-Mark (distributor to convenience stores) often reports gains on its inventory of cigarettes as manufacturers consistently raise prices. The consumer can replicate this strategy by buying pants, shoes (Foot Locker recently reported higher average selling prices), or whatever else in their life is going up in price.

My latest investment idea is to corner the market of men’s size 11.5 running shoes (my size). It’s my hedge against rising consumer inflation, possible trade wars, and import taxes. I’ll make a killing assuming retailers continue to reduce inventory and the world’s largest shoe producing nations say, “No more shoes. Start over with making shoes. They’re all gone.”

You know stocks are expensive when comedians become your best idea generators. How appropriate!

Buffett 1999 vs. Buffett 2017

This may sound awful coming from a value investor, but I don’t read Berkshire Hathaway’s annual reports cover to cover. I did earlier in my career. In fact, I’d eagerly await its release, just as many investors do today. However, over the years I’ve gravitated more to what makes sense to me and have relied less on the guidance from investment oracles such as Warren Buffett (see post What’s Important to You?).

While I know significantly less about Warren Buffett than most dedicated value investors, it seems to me that he has changed over the years. I suppose this shouldn’t be surprising as we all have our seasons. And maybe I’m the one who has changed, I really don’t know. But I remember a different tone from Buffett almost twenty years ago when stocks were also breaking record highs. It was during the tech bubble when he went out of his way to warn investors of market risk and overvaluation.

I found an old article from BBC News with several Buffett quotes during that period (link). The article discusses Warren Buffett’s response to a Paine Webber-Gallup survey conducted in December 1999. The survey showed that investors expected stocks to rise 19% annually over the next decade. Clearly investors were extrapolating recent returns far into the future. Fortunately, Warren Buffett was there to save the day and help euphoric investors return to their senses.

The article states, “Mr Buffett warned that the outsized returns experienced by technology investors during 1998 and 1999 had dulled them into complacency.”

“After a heady experience of that kind,” he said, “normally sensible people drift into behaviour akin to that of Cinderella at the ball.

“They know that overstaying the festivities…will eventually bring on pumpkins and mice.”

I really like and can relate to the Warren Buffett of nearly twenty years ago. If I could go back in time and show the 1999 Buffett today’s market, I wonder what he would say. I’d ask him if investor psychology and the current market cycle appears much different than the late 90s.

Similar to 1999, have investors experienced outsized returns this cycle? From its lows in 2009, the S&P 500 has increased 270%, or 17.9% annually. This is very close to the annual returns investors were expecting in the 1999 survey, when Buffett was warning investors.

Have investors been dulled into complacency? Volatility remains near record lows, with every small decline being saved by central banks and dip buyers. Investors show little fear of losing money.

Are today’s investors not Cinderella at the ball overstaying the festivities? It’s the second longest and one of the most expensive bull markets in history!

There are of course differences between 1999 and today’s cycle. While valuation measures are elevated, today’s asset inflation is much broader than in 1999. The tech bubble was extremely overvalued, but narrow. A disciplined investor could not only avoid losses in the 1999 bubble, but due to value in other areas of the market, could make money when it burst. Given the broadness of overvaluation in 2017, I don’t believe that will be possible this cycle. In my opinion, it will be much more challenging to navigate through the current cycle’s ultimate conclusion than the 1999 cycle.

The broadness in overvaluation this cycle makes Buffett’s recommendation to buy a broadly diversified index fund even more difficult for me to understand. Furthermore, given the nosebleed valuations of many high quality businesses, I’m not as confident as Buffett in buying and holding quality stocks at current prices. It again reminds me of the late 90s. At that time, there were many high quality companies that were so overvalued it took years and years for their Es catch up to their Ps. But these are important (and long) topics for another day.

Let’s get back to Buffett 1999. I find it interesting to compare him to Buffett 2017. Surprisingly, Buffett 2017 doesn’t seem nearly as concerned about valuations this cycle. Buffett writes, “American business — and consequently a basket of stocks — is virtually certain to be worth far more in the years ahead [emphasis mine]. Innovation, productivity gains, entrepreneurial spirit and an abundance of capital will see to that. Ever-present naysayers may prosper by marketing their gloomy forecasts. But heaven help them if they act on the nonsense they peddle.”

You can include me as a naysayer of current prices and valuations of most risk assets I analyze. Based on the valuations of my opportunity set, I’ll take the advice from another naysayer – the Warren Buffett of 1999. As he recommended, I plan to avoid extrapolating outsized returns and will not ignore signs of investor complacency. I plan to remain committed to my process and discipline. By doing so, when the current market cycle concludes, I hope to achieve two of my favorite Warren Buffett rules of successful investing – avoid losing money and profit from folly.

 

Bubble Watching

I always get a kick out of central bankers and market strategists who state they don’t see signs of market froth. How can that be? During periods of overvaluation, it can be seen clearly in prices, valuations, and yields. It can also been seen all around us in everyday life.

This morning I drove my son to school and took the scenic route along Ponte Vedra Blvd. It’s a very nice five mile drive along the ocean. The entire drive is littered with new homes or new homes under construction. These are very nice and very big homes that are being built where very nice and very big homes once stood. I call it the teardown bubble. Although driving through the teardown bubble is challenging given the number of dumpsters and construction trucks, it’s a worthwhile drive if you enjoy bubble watching (a hobby of mine).

During the last credit and market cycle, condos were sprouting up everywhere near the beach. This cycle is different as it’s more high-end homes versus condos. It appears the 1%’ers are trading in some of their gains on financial assets to raze the old and build the new. I suggest the Federal Reserve rent a tour bus and take a drive down Ponte Vedra Blvd before their next Fed meeting. After the tour, I suspect they’ll have trouble arguing their policies have not created excesses, imbalances, and inequality. At the very least, they will no longer be able to say they haven’t seen signs of market froth.

Shortly after I returned from my drive through Asset Inflation Boulevard, I came home and turned on the television. On the screen was a city’s skyline filled with construction cranes. At first I thought it was Nashville, or the Dubai of the South (thanks to a reader for the perfect description). But no, it wasn’t Nashville, it was London. Whether it’s Nashville, London, or Ponte Vedra Blvd, in areas populated with beneficiaries of asset inflation and credit growth, you will find significant levels of construction activity, and yes, construction cranes (a historically reliable sign of cycle froth).

Signs of this cycle’s excesses are obvious, in my opinion. For investors fully committed to the current cycle, these signs are either invisible or believed to be sustainable. I’ll admit, the duration and durability of this cycle has been impressive. And with help from the “unlimited” global central bank bid, maybe it can last longer. I really don’t know, but I do believe signs of froth are clear. Similar to past cycles, identifying these signs has been beneficial in avoiding unnecessary losses when the boom inevitably turns to bust. 

Picture of London below. Out of curiosity, I placed it above a picture of Nashville’s skyline to compare. It’s fun to play count the cranes!

Have a great weekend!

Nashville: