The boring Russell 2000 Value is now up +54% from its February lows, +34% YTD, and +20% over the past month. Amazing, especially considering the less-than-stellar operating results and inflated valuations of many of the small cap value stocks I follow. Moves in small caps like this can happen, but they usually occur off inexpensive valuations and depressed profits, not near record valuations and stretched profit margins.
The key to a good speculative buying frenzy (besides trillions of QE) is the absence of facts and data to support or dispute the move. For example, a company without revenues or earnings can be priced more outrageously than a mature company generating predictable revenues and earnings. In effect, it’s difficult to make things up, or make aggressive assumptions with an established business. As stocks soar higher, few companies are currently reporting operating results and outlooks. Without the burden of facts and fundamentals, investors are free to let their imaginations and assumptions run wild.
Some popular assumptions investors are making post-election relate to business-friendly changes in tax, regulation, and fiscal policy. Since the ultimate impact these policies will have on deficits, corporate earnings, and interest rates is highly uncertain, speculators and investors can form whatever assumptions they need to justify their positioning. In effect, we’re in a period when aggressive valuation assumptions aren’t and can’t be supported by data or existing trends. Earnings reports and preannouncements begin early to mid-January 2017. Until then, it’s an assumption free for all.
While the majority of corporations won’t report until early next year, some valuable information continues to trickle in. For example, Casey’s General Stores (CASY) reported earnings last week and provided commentary that I thought was helpful and timely. Casey’s owns and operates 1,900 convenience stores in 14 Midwest states. Earnings were below expectations, but were mainly lower due to declining margins on gasoline sold. More important, as it relates to consumer spending and business activity, was the performance of their grocery and prepared foods divisions – both reported results below company goals.
Commenting on results management said, “A slowing of in-store traffic and tightening of consumer spending caused by the ongoing pressures in our operating area adversely impacted same-store sales throughout the quarter.” As it relates to prepared foods management commented, “Consistent with reports from other food service operators, we continued to experience a softening of in-store traffic that resulted in same-store sales below our annual goal.” Regarding its industry management noted, “Sales in our unchanged store base were below our expectations, which we attribute generally to the challenges in the broader convenience and food service industry.”
Similar to several consumer companies reporting weaker than expected traffic and comps, Casey’s plans to increase prices. Management stated, “To help offset some of these pressures, effective November 1, we implemented several strategic price increases on select items. These increases should represent approximately 1% to 1.5% benefit for the total prepared food category going forward.”
Another theme for many consumer companies is rising labor costs. Management touched on this as well stating, “We remain committed to offering competitive wages and benefits in an effort to be the employer of choice. With this in mind, we feel that is the right decision to uphold the commitment that we made to our employees and we’ll go forward with the applicable salary changes.”
As it relates to the current operating environment, an analyst asked if management has noticed any “change in trend and traffic or consumer sentiment” in November. Management said that they don’t like giving short-term guidance, but did state weather may benefit results considering it was the second warmest November on record in their market area. They also pointed out that the Department of Transportation announced miles driven were positive. Although weather and miles driven could benefit the current quarter, management pointed out they have a “heightened awareness of our consumer and their spending.” Management talked about the “basket ring” and that sales inside the store “did step down sequentially from Q1 down to Q2. And so we’re getting the traffic definitely at the pumps, just at this point, I think we have a consumer cautiousness that just is not pulling them into the store to buy other products.”
Management was also asked if they noticed any changes since the election. Management said, “I can’t necessarily sit here and say how it affected us or affected us all. But certainly it’s out there and many of us had some anxiety either direction. And a lot of companies as you pointed out are reporting maybe a little bit of I wouldn’t say, a sigh, a sigh relief, but certainly an uptick in their business. I guess, at this point we wouldn’t be able to extrapolate anything like that into our business.”
And finally, the Marlboro Red Consumer Sentiment Indicator (the MRCSI) continues to flash yellow as consumers move more towards packs versus cartons. However, the shift to generics appears to have slowed. Management stated they “didn’t quite see that here in the second quarter but that may continue, so we did see a deceleration in cigarette volume or sales in Q2 relative to Q1 and certainly that’s a reason for the deceleration in comps from that period of time. I think that has to do more with kind of that consumer spending and tightening of the mindset that we talked about earlier.”
Thank you Casey’s General Stores for the timely update and informative commentary. While it’s not enough information to come to a conclusion, it supports what I’ve noticed with other recently reported quarterly results – the business environment doesn’t appear to be changing meaningfully. Although I don’t expect Q4 results to differ materially from Q3, I remain open-minded to an improving operating environment, especially with businesses that are beneficiaries of asset inflation and have easier year over year comparisons (such as energy and some industrials). However, at this point, despite higher equity prices and investor confidence, I have not seen sufficient evidence to convince me that there has been a broad lift in consumer spending or economic activity.
Considering where we are in the market and profit cycles, along with their drivers, I have no intention of making speculative assumptions to justify extraordinarily expensive equity valuations. And if I do adjust my valuation assumptions, I will not change one variable without considering how other variables will be impacted. As I’ve stated in previous posts, valuation variables do not exist in a vacuum – changes in one often requires changes to others. For example, given the possible benefits from new tax and fiscal policy, I suspect some investors increased their cash flow and growth rate assumptions. To justify paying higher prices, I also suspect some investors did not increase their required rates of return concurrently, even if higher interest rates would be a logical assumption in an environment with higher growth rates. Whatever it takes, I suppose.
It is times like these that I am very thankful I am not a relative return investor. As an absolute return investor, I don’t feel the need or pressure to make aggressive assumptions, manufacture opportunity, and chase performance. From a safe distance, I can watch the herd of relative return investors trip over themselves to buy the same stocks at record highs and near record valuations. While fascinating to observe, the relative return game is serious business. Violent moves like we’ve seen over the past month can cause large swings in relative performance, assets under management, and make or break a portfolio manager’s career.
Imagine being a relative return portfolio manager. Now imagine that it’s November 1st and you’re beating your benchmark and peers by 300 basis points. In the relative world, that’s a big deal. You’re only two months away from a substantial bonus and you’re beginning to think the vacation house you bought last year wasn’t such a bad idea. Life is good. Fast forward a few weeks and now you’re trailing your benchmark by 500 basis points and you just went from being the office hero to fearing for your job (and bonus!). Performance panic ensues.
As you watch the stock market spike higher, the walls start closing in on you and your hands begin to sweat — it’s difficult to concentrate. Instead of congratulating you on performance, your colleagues ask you about the weather, your weekend, and if you plan to see the new Star Wars movie. You have to rewrite your annual letter changing the theme from what you did right to what you did wrong. You think about all the stocks you should have bought and start to think about the stocks you can still buy. It suddenly hits you that it’s not too late – there is still time to catch up. You put together a list of stocks that are acting well and you believe will end the year strong. Trades are made. You feel better and relative performance begins to improve immediately. You swear off ever holding cash and stocks that “aren’t working” again. Multiply this by 10,000 and by billions of dollars and that’s where we are today – a classic year-end performance panic.
Chart of Russell 2000 Value (below):
Loyalty, Prudence and Care or year-end performance panic? (Hint: the Russell 2000 Value trades at 34x earnings, 20x EV/EBITDA, and 1.9x EV/Sales, or well above most generous takeover valuations)