The Long Run

This note was originally published at 8am on June 28, 2011. INVESTOR and RISK MANAGER SUBSCRIBERS have access to the EARLY LOOK (published by 8am every trading day) and PORTFOLIO IDEAS in real-time.

“Avoiding danger is no safer in the long run than outright exposure.  The fearful are caught as often as the bold.”

Helen Keller


It is difficult to invest for the long term.  In order to do so, the key characteristic an investor must have is permanent capital.  The best example of permanent capital is Berkshire Hathaway, Warren Buffett’s investment vehicle.  Since Berkshire recently hit a 52-week low, in the short run, it has been a bad investment.  In the long run, of course, Berkshire has been a fabulous investment.


From December 31st, 1987 to the close yesterday, Berkshire “A” shares have returned ~3,770%+.   Over the same period, the SP500 has returned ~415%+.  In the long run, it is obviously difficult to debate Buffett’s success as an investor.  Unfortunately, very few investors can operate for the long run because of a lack of permanent capital and an unwillingness of those that provide the capital (limited partners) to suffer volatility. 


Naively many investors attempt to emulate Buffett’s performance by purchasing stocks that emulate his criteria.  In aggregate, studies show that cheap stocks with clean balance sheets will outperform over time if bought well.  Obviously, the challenge when emulating Buffett, though, is to assess the moats of a company and barriers to entry of an industry.


As Buffett wrote in his 1992 letter to Berkshire Shareholders:


“An economic franchise arises from a product or service that: (1) is needed or desired; (2) is thought by its customers to have no close substitute and; (3) is not subject to price regulation. The existence of all three conditions will be demonstrated by a company's ability to regularly price its product or service aggressively and thereby to earn high rates of return on capital. Moreover, franchises can tolerate mis-management.  Inept managers may diminish a franchise's profitability, but they cannot inflict mortal damage.”


The challenge of finding a long term economic franchise is that very few exist, or are sustainable.  At one point, the newspaper industry was a prime example of an economic franchise.  The newspaper was needed, in many markets had limited competition (think the Buffalo News), and pricing of newspapers was not regulated by the government.  While arguably the newspaper industry did represent franchise-like investments during periods, those investors that held these franchises in perpetuity are likely not happy today. 


The key way to “avoid danger in the long run” is to remain flexible, not duration specific.  I appeared on the Kudlow Report a few months back and one of the other guests was extolling on the virtues of being a long term investor and indicated that his firm has an average holding period of four years.  In theory, that’s fine if you have the process and team to execute on a long term holding period.  If you are investing for the long term, which for this discussion we’ll just consider beyond three years, it requires just as much work, if not more, than if you are an intraday trader.


The primary reason investing for the long term requires more work is because in the short term, assets will get mispriced.  Much of this can be attributed to behavioral finance and fear.  When assets get mispriced, such as in the market dislocation during the subprime debacle, it requires strong conviction in the research process to believe the fundamental story and to continue to buy, or even hold, as an investment is dramatically underwater.  While many fund managers claims to be adept at buying while there is “blood in the streets”, very few actually can effectively time purchases.  The world is replete with studies that show both professional and individual investors classically sell at the bottom and buy at the top.


Given the challenges with true long term investing and the reality that most cannot do it, we emphasize three investment durations in our research: TRADE (3 weeks or less), TREND (3 months or more), and TAIL (3 years or less).  In theory, at least based on how we analyze timing and risk, they are all related, so a TRADE idea can become a TREND idea and so on. Thus, a rigorous daily research process is critical to our success (hence the early mornings).


Shifting to the short term, there are a number of data points from the last 24 hours that I wanted to flag as fundamental to some of Hedgeye’s key investment views:


First, the European sovereign bond markets continue to signal that the worst is yet to come for sovereign debt on the continent.  Even as equity markets seem to be lightly cheering positive developments yesterday, bond yields have barely budged.  In fact, Greek 10-year yields are at 16.5%, Irish are at 12.1%, Portugese are at 12.1%, Spanish are at 5.7%, and finally Italian 10-year yields are at 5.0%.  Specific to Greece, civil unrest continues to accelerate as Greek trade unions are planning a 48-hour strike to protest austerity measures that will be voted on Thursday.  We remain long German equities via the etf EWG and short Spanish equities via the etf EWP.


Second, Premier Wen Jiabao provided us an early view on Chinese inflation for the full year yesterday.  He indicated on Hong Kong-based Cable TV that while he sees difficulties in reaching a full year inflation target of 4 percent, inflation “can still be kept below 5 percent”. This supports our view that the proactive monetary tightening that China has implemented will lead to steadily decelerating inflation in the back half of 2011 and marginal dovishness out of the People’s Bank of China.  We are long Chinese equities via CAF.


Finally, New Jersey officials are purportedly in negotiations to secure a temporary $2.3BN bank loan to cover a state cash shortfall.  New Jersey needs the cash to pay various bills between the start of its fiscal year on July 1st and the mid-summer bond offering.  We’ve been consistently negative on State and Local level finances and this provides incremental support to the view.  While many States are constitutionally obligated to balance budgets, it will be challenging and will likely require additional municipal bond issues as federal government support will be largely non-existent in fiscal 2012.  Further, State and Local level austerity will be a drag on economic growth more broadly.  We currently have no position in the municipal bond market.


Good luck “avoiding danger” out there today,


Daryl G. Jones

Director of Research


The Long Run - Chart of the Day


The Long Run - Virtual Portfolio



The Macau Metro Monitor, July 1, 2011



June GGR came in at MOP 20.792BN (HK$ 20.186BN, US$ 2.593 BN), up 52% YoY.



Insiders claim Caesars Entertainment is hot for Kinmen and reportedly interested in building a comprehensive recreation and entertainment facility on one of the county’s islands.  MPEL CEO Lawrence Ho also made a recent trip to Kinmen.  Casino rules may be finalized by the MOTC (Ministry of Transportation and Communications) in late 2011.  A local referendum will follow.


According to Soufun Holdings, China home prices growth in June slowed to +0.4%, from +0.5% growth in May.  This is the 10th straight month of gains. Shanghai home prices rose 0.1% MoM (+0.3% MoM in May), while those in Beijing dropped 0.1% MoM (+0.2% MoM in May).

Chicago PMI? A Golf Clap at Best

Conclusion:  Our interpretation of the Chicago PMI is that it is a golf clap at best.  We are adding to our short position in U.S. equities (via SPY) and long position in U.S. Treasuries based on better prices created by today’s PMI story telling.


There is no disputing that the headline Chicago PMI number reported today was better than expectations.    The median forecast of analysts was for 54.0, and the number came in at 61.1.  This was also a sequential improvement from May, which was a 56.6 reading.  So, is this positive on the margin? Sure, but if we look at the longer term, even a 61.1 PMI isn’t overly exciting.


While not exactly the long term, we have attached below a chart of PMI going back twelve months.  The key take away from this chart should be the dramatic decline of both May and June from the first four months of 2011.  The PMI reading for January to April of 2011 ranged between 66.8 and 71.2.  So, the Chicago area economy continues to trend well below economic levels from earlier in the year.


There are a number of details within the report that are worth flagging:

  • Order backlog in June dropped to 49.1, which was a sequential decline from May’s reading of 51.7 and the first drop below neutral since September 2010;
  • Inventories saw a “precipitous decline” from May and came in at a reading of 46.9 in June versus 61.6 in May;
  • Prices paid are still expanding, albeit at a slower rate and declined to 70.5 in June from 78.6 in May (Deflation of the Inflation). 

A number of comments from the survey are also worth highlighting:

  • “Incoming orders have definitely slowed down. Several orders we expected to see are currently on hold. Hopefully something will break or the 4th quarter is going to look sad”;
  • “It looks as if manufacturing is showing signs of slowing down”; and
  • “There may be a little softening coming but it’s too early to tell.” 

While the headline number is better than expected, which is getting equities going today along with quarter end window dressing, the key perceived positive is a drawdown in inventories.  This suggests that there could be some inventory building in the coming months, which would drive overall economic activity.  That said, the last time we saw the inventory reading drop precipitously was June 2010 when the reading dropped from 54.2 in May 2010 to 47.2 in June 2010.  In the ensuing months, not only did we not see economic activity pick up, more broadly Chicago PMI actually began to decline into August 2010.


Suffice it to say, we don’t find today’s Chicago PMI all that exciting.  In fact, we actually find the drop in orders to below 50 outright concerning, along with the selected commentary.  As a result, we are using the over reaction of both the equity and bond markets today to add to our short positions in the SP500 and long position in U.S. Treasuries.  Short high, buy low.


Daryl G. Jones

Managing Director 


Chicago PMI? A Golf Clap at Best - 1

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We decided to let our intern, Allen Davis, away from the desk for a few hours to check out some Chipotle locations.


Despite the heat, he was enthusiastic about the idea of visiting as many Chipotle stores as possible in Manhattan.  While he likes to eat, being a Yale football player, he wasn’t being sent to sample the food.  His job was to speak to store employees about the impact on traffic, if any, of the recently reported $0.50 increase in prices implemented at the company’s NYC restaurants.  Below is his account of the experience.


“Wednesday was a big day for me. I had squat clean and bench for my workout after market close, but a day long warm-up walking the streets of New York (not in the classical sense). My mission: visit every Chipotle on the island of Manhattan in an effort to gain some insight into recent traffic trends following the reported $0.50 increase in prices at New York City Chipotle restaurants. Major roadblocks would include annoyed managers, midday lunch rushes, and a general fear of subways.  In the end, it was impossible to make it to every store on Manhattan but I managed to survey 19 stores and got a response 74% of the time.  The general consensus was that, following the price increase, not much had changed.           


The $.50 price increase, partially necessitated by Chipotle’s continued commitment to buying as much of its meat and produce as it can from local organic sources, didn’t seem to be a headwind to traffic, according to the managers I spoke with.  None reported a decrease in sales and the only location that would provide me with a rough weekly sales average said that they had done 1-2k incremental sales following the price increase.  While a lot of this is probably just the $.50 price jump pushing revenue, it does suggest that traffic is staying consistent, another point that many managers made. This makes sense when you consider the consumer that Chipotle typically services and, of course, the location of the stores I surveyed.


As the CEO of Taco Bell recently admitted via a now-infamous BMW vs Hyundai metaphor, CMG doesn’t have a product that sells to the same people that would run out to Taco Bell and get 8 burritos for a buck each (source). They sell a higher quality product to a more upscale, and perhaps more eco-conscious, consumer. Before CMG took price, a burrito with guacamole, which costs $2.25 extra, was around $8.50 for chicken, closer to $9.00 for steak. While this isn’t an extravagant expense for some, it isn’t a totally insignificant one either. $8 is more than an hour’s work for many workers and, in cities like NYC where the cost of living is high, many may balk at paying such an amount for a meal.  On aggregate, though, people who spend $8-$10 at Chipotle in New York seem to be loyal to the brand, have the willingness and ability to pay the price.   In fact, many of the managers I discussed the price increase with told me that the majority of customers did not notice the change and, among the small number that did, very few complained.


Just today, the results of an Eco Pulse survey found that, when asked “Which is the best description to read on a food label,” the terms “natural,” “organic,” and “grown in the USA” accounted for 76% or responses (source).  From a marketing perspective, this bodes well for CMG even when they bump their prices because, since the Chipotle customer is willing to go to the expense to buy the product, the company can reap the benefits of touching on all of these target marketing terms. They can afford to pass off price to a greater extent, and do it in a more up front manner, than a company like McDonald’s. When MCD started charging $.19 more for the second slice of cheese on double cheeseburgers, the reaction was negative, but that wasn’t indicative of reactions to all price increases. MCD had bumped the price of a favored item by almost 20% to a lower income-bracket consumer. CMG’s change was blanket and on a more upscale consumer which I think is the reason it is having little effect on anything according to the managers."




Howard Penney

Managing Director


Rory Green


R3: FDO, GIS, WMT, Online Taxes



June 30, 2011





  • When pressed on their cautious view regarding unit volume in a rising price environment at levels similar to 2009, management of General Mills offered the some color worth noting. Back in ’09, there was a significant shift from consumers eating out back to shopping in the grocery store, which drove both unit growth and pricing. Since eating away from home hasn’t rebounded, there’s no benefit this time around to drive the supply of volume. A similar parallel can be drawn to consumers trading down to department and discount stores – a tailwind that will be sorely missed with higher prices starting to flow through the supply chain. 
  • In their first presentation since former CEO Rubel’s departure, PSS’ interim CEO Mike Massey highlighted among recent changes a refocused effort back toward the lower-end consumer. As part of these efforts, the company will lower key price points and offer more units available at the entry-level.
  • In a rare case of admission, FDO’s CEO Howard Levine admitted that his +5-7% comp guidance for Q4 is indeed aggressive. The  confidence in achieving it comes from  several initiatives underway including an accelerated store renovation plan (now 900 by yearend up from 600-800), increased store openings, and additional planned promotional activity in select categories that has been well received so far this quarter.



California Passes Web Sales Tax - Joining several other states, California Gov. Jerry Brown on Wednesday signed legislation to require out-of-state Internet sales companies to collect and remit state sales taxes. The law takes immediate effect. The bill expands the definition of a company having physical presence in the state to require collection, aside from having an actual store. Now companies with subsidiaries in California or business relationships that refer potential customers — even a Web site link on an unrelated site — are required to collect sales taxes. <WWD>

Hedgeye Retail’s Take: The latest state to pass online tax legislation further constricts the options for “safe havens” where internet-based retailers can operate. There will be additional one off agreements similar to the one Amazon struck with Indiana – essentially exchanges employment guarantees for tax amnesty, however, a national standard will be the game changer in this battle. We strongly believe it’s still a question of when, not if.


Wallmart Pumps Out the Fuel Savings - Walmart announced that it will offer customers savings of 10 cents a gallon on all fuel, gas and diesel at participating Murphy USA and Walmart gas stations.  The reduction is part of a 90-day Rollback program. "Our customers have told us that high gas prices are a top budget concern, nearly as large an expense to their households as food and groceries," said Stephen Quinn, chief marketing officer. "We listen to our customers and because we know they are feeling squeezed by gas prices, we're implementing this gas Rollback to help them save, especially during high travel summer months." <RetailingToday>

Hedgeye Retail’s Take:  While this may actually prove to be a loss-leader for Wal-Mart, an additional 10 cents off basically doubles the savings if using cash at the pump as well. A 5% discount is likely to result in some much needed traffic.


Living Social Moves Ahead With IPO - Online daily deal site LivingSocial is meeting with banks to discuss an initial public offering of about $1 billion, according to a source familiar the situation. The amount values the Washington, D.C. based company in the range of $10 billion to $15 billion, according to the source. A representative for LivingSocial declined to comment. LivingSocial is the latest Internet startup seeking to woo investors who are piling into social media companies such as LinkedIn, Twitter, Groupon and Facebook. Online gaming company Zynga is expected to file for its IPO on Thursday that could value the company as high as $20 billion. LivingSocial is the No. 2 U.S. social deal site behind Groupon, which filed for its public debut and plans to raise $750 million that could value the company at $15 billion to $20 billion. <PRnewswire>

Hedgeye Retail’s Take: Surprise, surprise. A valuation there would suggest a solid appreciation of AMZN’s $175mm stake invested last year, which may now stand at close to $1-2Bn in value. 


Gap Sets Plans for South American Expansion - Gap Inc. hopes to open at least 26 stores in South America by 2016 as it continues to grow its global franchise, according to Carlos Alberto Cartoni, co-owner of Gap’s Chilean franchise partner Komax. After reportedly courting the U.S. brand for 20 years, Komax will open Gap’s first store, an 8,600-square-foot South American flagship, in Chile’s capital Santiago in early November. As part of the franchise agreement, Komax will install six Gaps and three Banana Republics in a first expansion phase by 2013. Depending on its success, the retailer, which also manages the Polo Ralph Lauren and The North Face trademarks in Chile, will roll out another six Gaps and five Banana Republics by 2016, Cartoni revealed. Under the expansion, Gap will also arrive in other main Chilean cities Antofagasta and Viña del Mar, he added. Santiago de Chile-based Komax will buy Gap’s clothing at wholesale prices that will include the U.S. retailer’s markup and won’t pay royalties. Apparel will be sourced directly from Gap’s global factories and will be tailored to Chilean consumer tastes.  <WWD>

Hedgeye Retail’s Take:  Not new news, but we are getting closer to the first Gap store in South America albeit a few months later than originally anticipated (Sept.). We suspect this goal of 26 stores is likely to prove conservative as the growth-starved retailer looks to capitalize on one of the few international markets yet to be tapped. In fact, we wouldn’t be surprised to see additional franchise agreements struck in other South American countries before long for that very reason. This company is so hard pressed to find obvious areas for growth.


Williams-Sonoma Heats up International Expansion - Building on its May launch of an international sales program for its youth-focused brand, PBTeen, in 75 countries, Williams-Sonoma Inc. is taking its other brands international this month, said Pat Connolly, executive vice president and chief marketing officer. The housewares and furnishings retailer, No. 25 in the Internet Retailer Top 500 Guide, by the end of June will enable all of its e-commerce sites for international shipping to 75 countries, Connolly told analysts last week at the Goldman Sachs Second Annual Dot Commerce Day. The company also operates,,, and “While at first this will be more of a service channel than a sales channel, we see it as the first step in ourinternational expansion,” he said. “We’ve hired senior leadership in this area, and foresee a strategy of entering new.” <InternetRetailer>

Hedgeye Retail’s Take: A natural progression for WSM’s aggressive international effort ahead of what will inevitably lead to a store expansion effort. While the initial push with free international shipping made plenty of headlines, it’s primarily be these core brands/products that international consumers will be looking for.


Best Buy to Shrink Store Footprint -  Best Buy plans to reduce its store size by subleasing store space to smaller retailers, according to The Los Angeles Times. The chain’s new stores will be in the 36,000-sq.-ft. range, down from its current 45,000-sq.-ft. model.  "We can reduce our overall square footage while actually increasing our presence," Best Buy CEO Brian Dunn said at the company's annual shareholder meeting this week. "It's an opportunity to capture cost savings and get ourselves 'right size.'" According to the report, the new stores that move into the Best Buy space will require their own restrooms, electrical systems and air-conditioning in addition to floor-to-ceiling walls separating the businesses. <RetailingToday>

Hedgeye Retail’s Take:  A 20% reduction in square footage makes a lot of sense. Some categories like entertainment and even consumer electronics have been shrinking of late and are likely targets of where the retailer can cut back. Our sense is that not too many customers would put up a fight if BBY reduced its eight isles of DVDs down to two.  


Coach Launches Mobile Commerce - Coach, which boasts nearly 277,000 fans on Twitter and 2.1 million on Facebook — enters a new digital realm today: mobile commerce. Developed through Usablenet’s technology platform, the feature will give customers the ability to purchase directly from their mobile devices and, if they choose, the option to pick up their merchandise at a local Coach retailer. “It’s nice to provide instant gratification and link our online and offline businesses,” said David Duplantis, Coach’s senior vice president of global Web and digital media. “It’s all about demand. Our customers are mobile by nature. Building a site that allows them to easily browse and purchase our products on their mobile devices is a seamless evolution and way for us to provide excellent customer service.” <WWD>

Hedgeye Retail’s Take:  Store site pickup is a key feature in saving consumer’s time. Execution will be critical here.




As the dollar has gone down week-over-week, the up-moves in agricultural commodities were more pronounced than the down-moves. Coffee, sugar, corn, and chicken wings all led the way, while rice and pork declined week over week.  Heading into earnings season, it will be interesting to take stock of companies’ updated full-year commodity inflation guidance versus what it was at the time of the last earnings call.  Some companies, like CAKE, are not guiding to realistic levels of inflation, in our view.







Coffee prices are up 6.8% over the past week as rising demand and higher fuel costs continue to impact the price of the commodity.  For the coffee concepts, SBUX, PEET, GMCR, MCD, DNKN, CBOU, and THI, rising commodity costs are a serious concern.  While some of these companies have prices locked in, to the extent that contracts may be coming up for renewal, prices are likely to burden restaurant-level margins sooner or later.  Below is a selection of comments from management teams pertaining to coffee prices from recent earnings calls:



  • PEET (5/3/2011): We believe we're better off lowering our earnings guidance by $0.10 this year and continuing with the plans we have in place than we would be curtailing spending activity or taking extraordinary pricing action that would be inconsistent with our long-term business interests, and the more sustainable long term cost of coffee we foresee.  As a result, you will see throughout our call today that we have a very strong performing fundamental business, but we have to buy some unusually high priced coffee in the short term, then we're not going to do unnatural things in reaction to an unnatural market environment short term. Hedgeye: prices were sliding as the dollar caught a bid but, over the last couple of weeks prices have swung higher again.  While it seems that prices may have been “unusual”, this elevated level of pricing may persist for longer than expected.
  • GMCR: (5/3/11): Before closing, I also want to touch on rising coffee costs and the effect of our business. Like others in the industry, we are closely watching coffee prices. When we announced our last price increase in September of 2010, coffee prices had increased roughly 30% from $1.45 to $1.90 per pound over the course of roughly three months. Since then, costs have continued to escalate, recently hitting historic highs of more than $3 a pound, a nearly 60% increase since September.  In attempt to offset rising green coffee costs, as well as increases in other input costs, we are currently in the process of raising prices for all packaged types. We expect that consumers will see an increase of approximately 10% at the point-of-purchase as the result of this price increase. We expect to see the full benefit of this price increase during our fiscal fourth quarter of 2011.  We generally fix the price of our coffee contracts three to nine months prior to delivery so that we can adjust our sales prices to the marketplace.  Hedgeye: Coffee has backed off the “historic” high of more than $3 per pound but is still at $2.60 plus and up over the last couple of weeks.  Demand remains strong; without a rising dollar, expect price to continue to pressure retailers.
  • SBUX (4/27/11): Regarding coffee costs, as I have indicated previously, we have fully locked our coffee costs for 2011 and are price-protected for a couple months into fiscal 2012.  As we progress through the balance of 2011, we will progressively take actions to secure our coffee needs and lock coffee costs for additional months into 2012. While we expect that the costs we pay for coffee may be higher in '12 than they are in '11, we remain confident that we can offset those increased costs and preserve our long-term earnings growth targets.  Hedgeye: SBUX is confident that it can pass on price and offset coffee inflation with other efficiencies.  It is interesting that it expects higher coffee prices in 2012 than in 2011, which would somewhat contradict PEET’s assertion that in May that prices at the time had been unusual.  SBUX expects worse prices to come.




Corn prices have bounced significantly of late as the dollar has declined, expectations of harvests in 2011 have dipped, overly moist fields have deterred farmers from planting, and ethanol production continues has depleted supplies.  Corn is an important commodity for the broader restaurant industry because it is used as feed by meat producers.  As prices in corn accelerate, it supports prices in beef, chicken, pork, and other meat markets.  Below is some recent management commentary pertaining to corn prices:



  • CMG (4/20/11): The only things we have locks on corn for most of the year, rice for the entire year, our tortillas and beans for most of the year as well.  Hedgeye: CMG will likely have to renew any corn contract at a level far higher than the one it currently holds. 
  • MCD (4/21/11): And so if the commodity markets move significantly from here and the main ones obviously looking at beef, looking at corn, wheat, coffee, et cetera, our guidance reflects where the markets are today. Hedgeye: Looking at where the prices of these commodities have gone since this quote, one would have to think guidance for commodity costs are going higher.




Chicken wing prices are ticking higher, as we have expected them to do – summer generally brings an uptick in prices as demand picks up.  See the chart below.  BWLD is certainly in the clear for 2011 but, the question mark as we progress through the back half of 2012, will be on prices in 2012. 


  • BWLD (4/26/11): For cost of sales, the traditional wing market continues to be favorable and the price of chicken wings for the first two months of the second quarter is averaging about a $1.02 per pound, which is lower than any quarterly price since 2003. It compares to last year’s average price for the second quarter of $1.51. Our Boneless Wings contract is extended through March of 2012 at flat pricing to 2010. Hedgeye: Traditional wings count for 20% of restaurant sales and boneless wings count for 19%.


Howard Penney

Managing Director





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