“You can choose a ready guide in some celestial voice. If you choose not to decide, you still have made a choice.”
–Neil Peart (and Descartes)
Fun fact: I have a tattoo on my left shoulder that says ‘Believe In Miracles’. It’s an image of an antique window shutter that my wife and I bought from a sweet elderly couple that was selling homemade crafts at a church art fair to earn a few extra bucks. They stenciled those three words on the shutter along with three red stars underneath them. It was the mid-1990s, we were just married, and had just gotten a massive blow by our ‘world class’ doctors who told us that we’d be unable to have children – ever.
The three stars on the painted shutter proved prophetic, as we welcomed our twin boys into the world just three years later, and our daughter two years after that. Score: Miracles = 3. Best Doctors Money Can Buy = 0.
Believe In Miracles, indeed.
While I’d encourage everyone who will listen to in fact “Believe In Miracles”, I’d strongly advise against making that a part of your investment process. There’s a time and a place for everything, but feelings and beliefs can get you into a world of trouble when you are managing real capital, and are employed in a world that keeps score.
At Hedgeye, we LOVE (yes, that’s a feeling) keeping score. Winners usually do. Our principles and processes consistently come out ahead of the competition. And it’s all #timestamped – the wins and the losses. #accountability, #transparency, and #trust. I’m tempted to get a tattoo of those Hedgeye founding principles on my other arm (I’m not joking).
At my core, I ‘Believe’ in those things too. I’m a founding Partner and a @Hedgeye ‘lifer’, after all. I owe everything to my Partners and the principles under which we operate.
Back to the Retail Macro Grind…
We operate in egregiously imperfect markets, with information coming from more sources today than at any other time in my 28-year career. Information and data has become a commodity. People – especially Hedge Fund analysts and PMs that are graded by daily P&Ls love having an information edge. That’s flat out reckless, and in some instances borderline illegal. But one information source that has been the constant over time is management of the very companies we analyze.
By my math, I’ve analyzed (in some capacity) roughly 17,000 earnings events during my career. To say that I’ve ‘been there, done that’ as it relates to consuming management messages is an understatement. I also spent time in the mid-2000s working at Nike, where I was part of the team that crafted the messages spawned for the Street’s consumption. Let’s be clear about something, what companies say is kind of like a sausage-making process. You DON’T want to see the mess of economic reality or the sheer mass of ‘unknowns’ that go into the messaging process, but what comes out the other end is neat, clean, palatable and sometimes quite tasty. It can also make you really sick when you over consume it.
One thing I can say for sure is that management teams – especially in Retail, which is a full contact sport – have forecast accuracy that is simply abysmal. These companies probably know their upcoming month’s results with 90% certainty. The quarter by 75%. The year by 50%, and the 1-3 year TAIL view by 25%. Yet the Old Wall rides company guidance like it’s gospel. Even the buy side is rarely off the company guidance – hence we wouldn’t see such outsized moves in the stocks when results deviate so meaningfully from the guide.
One thing I find particularly disturbing is the number of retailers that are messaging that the strength they have seen in margins and lack of promotional activity during the pandemic is sustainable on a go-forward basis. A ‘permanent change’ or a ‘secular shift’ as some are calling it. These are companies that largely have minimal-to-no Macro Process, and predominantly rely on what they see in Old Wall research reports and Mainstream Media to build their demand forecasts.
And let’s be clear about something, retailing is a lot like farming. When corn prices are high and margins are peaky, farmers chase margin, shift land resources from wheat, soy, etc…and plant as much corn as humanly possible. Then the market is flooded, prices crater, and margins immediately follow. That’s retailing to a ‘T’. When margins are as high as they are today from tight supply and strong (trailing) demand, management teams think they can make twice as much money if they order 2x the inventory. That works for a quarter. Maybe two. Then things come crashing down. To be clear, that dynamic is NOT represented in guidance for retailers today.
If believing those management teams is core to your process, then you lose a lot of money being at the center of the herd, and missing out on capitalizing on 3rd standard deviation moves in earnings and stock prices – on both sides of the trade/investment.
One of the most troubling trends we’ve seen quarter-to-date is the simply massive spike in inventories in US retail. We’re seeing the combination of companies over-ordering product because margins are so high (the corn farmer metaphor) as well as double ordering because supply chain challenges left money on the table over the last six months. We’re talking US inventories up 27% vs 2019 at Wal Mart and up 55% vs 2019 at Target, -- or about 2,000bps ahead of sales growth. Narrowing in on some large apparel sellers we see even bigger variances (vs ’19) with GPS inventories up 40% with sales up 2%, URBN with inventories up 39% with sales up 14%, and JWN inventories up 19% with sales down 5%. And companies are saying that merchandise margins are sustainable with inventory bloating into a decelerating consumer spending environment.
Can someone explain this to me like I’m a toddler? Because I simply don’t get it…and I’ve got a pretty massive analytical toolbox – and am a major student of what’s happened in the many retail cycles I’ve lived through in my career.
RetailPro subscribers know my thoughts on how to navigate this – but the crux is find companies on the long-side with a proven process to drive consumer demand and brand heat aside from simply ‘ordering more stuff’. These are companies that are building inventory short of what is likely to be end-demand. Hence, keeping margins high, or headed even higher. That’s CPRI, RH, NKE, TJX, CHWY, PLBY, DECK, DRVN, AMZN, WOOF – to name a few. Some of these stocks might look expensive, but they’re all likely to look cheaper over a TAIL duration at much higher prices and SIGNIFICANTLY higher earnings, cash flow and ROIC bases.
On the short side, you want to find names that have a diminishing brand heat, are over-ordering inventory, are exhibiting material confidence in the ability to sustain margins, and are guiding that the pandemic margin level is ‘the new normal’. We’re also looking for companies that are at the forefront of a new disturbing theme – which is using stock repo to prop-up earnings and the stock at a time when demand and margins are both fading. All in, short side you want to look at companies like ETSY, JWN, RVLV, DDS, M, RL, OXM, SNBR, WEBR, BBY – again to name a few.
We have twice that number of longs and shorts on our Position Monitor, which we update/change and publish for subscribers every Sunday night.
Quad 4 is alive and well. And our short book has been en fuego. Recent wins include SFIX (81% return by fading management’s bullishness into a structurally broken business model), CURV (66% return), SNBR (43%). But yes, some of our favorite longs have been shellacked – names like RH, PLBY, and CHWY. My sense is that we need one more Retail earnings season where we’ll see a major round of downward revisions – that comes in April/May – before the market starts to ‘get’ which companies have earnings juice and which do not. Until then, the outlook for the group is overwhelmingly bearish. This synchs well with when we’re likely to start to emerge from Quad 4 into Quad 1 – which is far more amenable to owning retail stocks. That’s when I expect to see our Best Ideas rip, but should still see Best Idea shorts fade as perceived earnings power evaporates.
Yes, some Quads are easier than others when it comes to being long and short retail, but I don’t like when things are ‘easy’. When things are gnarly like what we see emerging today – that’s when the best processes for alpha generation stand out. And I’ll stack ours against anyone.
