The BUE Consumer Report

Based on the valuations of my opportunity set, I’ve been bearish on small cap stocks. However, unlike your typical bear, I haven’t been negative on the economy – at least over the past year. In fact, I’ve been relatively positive on the operating environment for most small cap businesses. I began noticing the improving economy, along with rising wages and corporate costs, during the second half of 2017. Since then, the majority of the businesses on my possible buy list have performed well.

One of the interesting aspects of rising growth rates throughout 2017 and early 2018, was how consumer companies lagged their more cyclical peers (in growth and pricing power). Companies involved in transportation, energy, heavy industry, and construction, generated noticeably higher growth rates. However, the dispersion between cyclicals and consumer businesses appears to narrowing as organic growth of many consumer businesses has risen throughout most of 2018.

To help readers analyze the current consumer operating environment, The Bottom-Up Economist published a report today detailing the economy through the eyes of consumer businesses.

The report, on average, was slightly more positive than I expected. In fact, it was so positive, I reached out to my former analyst and BUE colleague and asked, “Are consumer businesses really doing this well, or have you been reading Tony Robbins again?” He replied, “Funny. But this is what our companies are reporting and what managements are discussing.” I responded, “With interest rates increasing, corporations responding to tariffs, and financial instability on the rise, our next consumer report may not appear as rosy.” He agreed, but reminded me that we are bottom-up economists, not economists for a sell-side firm. As such, it isn’t our job to predict the future or mold a narrative to fit our business needs. We should avoid subjectivity and describe the environment as it is, not as we want it to be. As bottom-up economists, we are simply relaying what businesses are reporting and communicating. In effect, we are messengers of real world economic data, company forecasts, and the opinions of management (but never ours).

Although I knew my BUE colleague was right, I remained reluctant to publish a bullish report on the consumer. My hesitation is likely a result of my history with asset bubbles. I know all too well what happens to the economy and consumer spending when an asset inflation boom abruptly turns to bust – consumer demand plummets.

With the financial markets finally responding to the sharp and consistent increase in short-term interest rates, I’ve become increasingly confident in my belief that the clock on the current market cycle is ticking (Tick Tock). As such, I’m also growing more concerned about the future operating results of many of the small cap businesses on my possible buy list.

While interest rates remain very low, there are already early indications that demand for large ticket items may be moderating. Although there are few signs of sharp declines, as Lennar (LEN) recently reported, home sales (I’d also include autos and RVs) may be taking a “pause” as sales and traffic trends slow. The degree and duration of any consumer pause remains unclear, but it is something I plan to monitor closely during the current earnings season. I’m also very interested in how companies are responding to rising interest rates, tariffs, wages, and inflation.

Speaking of inflation, last week the CPI and PPI reports came in low and below expectations. The Consumer Price Index only increased 0.1%. While I don’t analyze the government’s inflation data closely, a headline alerted me to the fact that according to the government’s data, used car prices declined -3% in September, or the most since the 1960s! The headline caught my attention as I just read CarMax’s (KMX) conference call, which described a different used car pricing environment. On the call, management did not talk about used car deflation, but instead was surprised by how well prices were holding up.

Management explained, “…we’ve seen unusual depreciation curves. In other words, normally, you see continued depreciation during this time of year, and we just really didn’t see that. It’s very different than in past years. It’s been very flat.”

Management had an interesting explanation as to why used car prices haven’t declined, stating, “I think there’s probably — and, this is just my belief — some of what’s driving that may be anticipation of tariffs on new cars and people speculating and trying to buy up used cars, but to be honest with you, I don’t really know why that is. New car prices are obviously still as high as ever, and they continue to go up.”

Bloomberg also picked up on the dispersion between the government’s data and other measurements of used car prices. In the article “Used-Car Price Plunge in CPI Contrasts with U.S. Industry Data”, Bloomberg pointed to the Manheim Consulting’s Used Vehicle Value Index, which set a record for the third straight month. Bloomberg quoted Stephen Stanley, a chief economist, who said, “This is one of the weirdest CPI reports that I can remember.” He went on to state the government’s used car data was “entirely at odds with the underlying reality in that market.”

Based on my bottom-up observations and analysis, I’m not convinced inflation is as low as advertised. And I’m not alone. While turning on CNBC last week to assess the media’s reaction to the recent stock market decline, I unexpectedly caught an interesting interview with Tilman Fertitta, CEO of Landry’s and owner of the Houston Rockets.

As a CEO and operator in the economy, Mr. Fertitta is very aware of rising costs and prices. As such, it shouldn’t be a surprise that he doesn’t buy into the “no inflation” narrative. In addition to pointing out wages are rising, Mr. Fertitta discussed his disagreement with the Federal Reserve’s view on inflation, stating, “People say there’s no inflation, but why does it cost us more to go to a restaurant, more to buy a car, more to stay in a hotel like this? There is inflation out there, and that’s where I disagree with the Fed.” Mr. Fertitta’s views on inflation are very similar to other CEO’s and management teams as we described in the BUE Inflation Report.

In summary, based on operating results released to date, many of the trends discussed in our Q2 2018 report, such as improving consumer demand and rising inflation, remain intact. Nevertheless, with many economic and market variables becoming increasingly volatile and uncertain, I believe the next two earnings seasons will be extraordinarily important and informative. I’m very interested in gathering timely information and data on inflation, wages, tariffs, and rising interest rates.

We plan to release our Q3 BUE quarterly report in November. I expect it to contain a tremendous amount of interesting and useful information. Until then, I hope everyone enjoys The Bottom-Up Economist Consumer Report.