Institutional Constraint

“We have many constraints as investors.”

-Seth Klarman


Baupost’s Seth Klarman is no stranger to going to cash. Neither is he shy about telling it like it is about how the game of Institutional Asset Management works. The aforementioned quote has nothing to do with the self-directed individual investor. It has everything to do with Institutional Constraints.


“Constraint”, per Wikipedia, “is an element factor or a subsystem that works as a bottleneck. It restricts an entity, project, or system from achieving its potential with reference to its goal.” Institutional Constraint isn’t what Klarman calls it, but I think he’d agree.


In Grant’s back in Q1, Klarman said “we want short-term performance, and are measured by this. There is enormous pressure from clients for short term performance. Mutual funds compete in a relative space. What’s important is absolute returns. The way people do this is forced mediocrity. To do absolute performance, you have to bet against the crowd sometimes.”


Sometimes betting against the crowd too early makes an investor wrong. Sometimes betting against your current positioning can make you less wrong. In a market like this, where Institutional performance chasing is one of the most misunderstood long-term TAIL risks we’re observing, price levels matter – big time. So does considering them on a multi-factor, multi-duration basis.


What does multi-factor mean?


First, let me tell you what it doesn’t mean:

  1. Point and click 1 factor models of simple moving averages (50 day, 200 day, etc)
  2. Being sucked into the Sentiment Vacuum of 1 topic (Debt Ceiling is the #1, #2, and #3 most read on Bloomberg this morning)
  3. Considering Global Macro risk from the vantage point of 1 country and/or 1 asset class (“what’s the Dow doing?”, c’mon)

Within the construct of Chaos/Complexity Theory (my modern day market practitioner’s answer to stale academic Keynesian Dogma), multi-factor is as multi-factor does. You need to build a risk management process that absorbs multiple price, volume, and volatility signals, across multiple asset classes, and across multiple durations.


If I had 10 Chinese Yuans for every person I’ve met in this business who says “well, the chart looks good”, I’d have a lot more money to fund Hedgeye’s growth. What, precisely, do charts mean? The answer to that is as simple as the deep simplicity Chaos Theory aspires to achieve. The chart looks as good as the math you have embedded in the picture!


If bells weren’t going off in your Global Macro Risk Management Process yesterday, I suggest you get a new one. Here are some of the alarms going off in mine that had me take my Cash position back up to 46% from 37% (where I started the day):

  1. EUROPE – both European stocks and bonds are turning into a proactively predictable train wrecks. Our research catalysts remain crystal clear (accelerating debt maturities for the majors through September) but, more importantly, now all of our TRADE and TREND lines across every major European stock and bond market (ex-Russia) have been broken and confirmed by volume and volatility studies.
  2. USA – stocks broke their intermediate-term TREND line of support (1320 in the SP500) and short-term bond yields finally busted a move above my 2-year yield TRADE line of resistance (0.41%).  Credit risk derived by market morons in Congress will be priced on the short-end of the curve (where Bernanke has tried to mark it to model for 2 years), so watch that 0.41% line like a hawk.
  3. GLOBALLY – China’s Shanghai COMP TREND line = 2831 (broken); India’s BSE Sensex TREND line = 18,578 (broken); German DAX TREND line = 7251 (broken); FTSE TREND line = 5985 (broken); SP500 TREND line = 1320 (broken); Russell2000 TREND line = 827 (broken); WTIC Oil TREND line = 103 (broken); EUR/USD TREND line = $1.43 (schizophrenic).

No one at Hedgeye has ever said 2011 Global Growth or 2H2011 Earnings Expectations were priced properly. If you close your eyes to all of my quantitative and research factoring across asset classes and just focus on those 2  - they are VERY large fundamental factors to consider having market impact above and beyond these yahoos in Congress.


Look, I’m not saying I got all of this right. What I am simply saying is that we, as a profession, can get a lot better at this if we just open our minds to re-thinking risk and re-working our asset allocations as the big factors are changing. The market doesn’t care about our respective investment styles, compensation mechanisms, or Institutional Constraints.


My immediate-term ranges for Gold, Oil, and the SP500 are now $1, $96.03-100.32, and 1, respectively. I cut my US Equity exposure to 3% (from 9%) in the Hedgeye Asset Allocation Model yesterday.


Best of luck out there today,



Keith R. McCullough
Chief Executive Officer


Institutional Constraint - Chart of the Day


Institutional Constraint - Virtual Portfolio

SKX: Respect The Cardinal Rule…

There are not a lot of cardinal rules in Retail investing. One of them is to never try to bottom-tick Skechers.



The tail end of fad-induced runs in retail are never pretty and SKX is no exception. While we’d like to give Skechers some credit for taking its lumps this quarter and getting more aggressive about reducing inventory, the reality is they had no choice. In addition to trying to sell through remaining product at the twilight of its relevance, SKX is starting to ship its next generation running and other ‘performance’ product for BTS. Of course "tests’have been positive", but aside from the fact that no CEO will ever state that tests aren't working, retailers are going to be understandably cautious before buying a front row ticket to toning part deux.


This one is going to take more than one quarter of pain to recover. We know full well that by the time we get any clarity, the stock will have moved on us. Furthermore, our SIGMA analysis below shows that despite the horrific (-65%) sales/inventory spread, that’s actually a sequential improvement from 1Q. The icing on the cake is that the most favorable stock price movement is associated with a move from the lower left quadrant to the upper left. And it looks like that’s where SKX wants to go.we think that some of this is already baked-into a low teens stock. And with a complete lack of clarity as to how the company unloads the remaining half of its excess toning inventory, coupled with the fact that we’re shaking out at $0.85 for next year we still don’t like this name here at $14.50.


Despite the silver lining of continued strength in the international business up 35%, domestic sales were down by the same magnitude and we expect this trend to continue driving total revs down 10% in Q3. While SKX is starting to rein in costs, gross margin variability continues to be a key issue that will have the company fighting to breakeven for the remainder of the year. Competition is getting tougher, and there’s no guarantee that this event is truly a kitchen sink event.


Again, there are not a lot of cardinal rules in Retail investing. One of them is to never try to bottom-tick Skechers.


SKX: Respect The Cardinal Rule… - 321

We Wouldn’t Want to be Glenn Stevens Right About Now

Conclusion: RBA Governor Glenn Stevens could shock the Australian economy into a pronounced economic downturn by looking through the current slowdown and hiking rates within the next few months, but given recent economic data it seems more likely that the tightening cycle has peaked in Australia.


Position: Short the Aussie dollar (FXA).


Reserve Bank of Australia governor Glenn Stevens has his work cut out for him. On one hand, he’s got to deal with a confluence of inflationary pressure at multi-year highs. On the other hand, broad-based slowing of Aussie economic data has become hard to ignore. Recessionary? Perhaps not, but we certainly would not rule that out at this juncture. Needless to say, we expect next Monday’s RBA monetary policy announcement and the accompanying commentary to be market-moving, given the increasingly divergent nature of Australia’s economic fundamentals.


We are short Australia’s currency as of this afternoon and think Stevens would be borderline crazy to hike rates at any point over the intermediate term. As we outlined in April, the bias of risks to Australia’s developed-world-beating benchmark interest rate of 4.75% is heavily skewed to the downside in our opinion.  Our view is divergent from the global FX market, which is is clearly pricing in additional RBA rate hike(s) on the heels of this week’s acceleration in CPI and PPI – both to 10-quarter highs.  Given the rapid appreciation of the Aussie dollar over the last twleve months (+23.3%), much of this is likely priced in to the currency, which makes the risk/reward compelling on the short side.


We Wouldn’t Want to be Glenn Stevens Right About Now - 1


Interestingly, both the interest rate futures market and interest rate swaps market are pricing in RBA hawkishness (on the margin) on the heels of today’s CPI report. Rate futures suggest a 28% chance of an RBA rate cut by December, down from 100% just two days ago. In the same time period, swaps market expectations for RBA rate cuts over the NTM nearly halved, falling from -42bps to -23bps, and those same expectations went from signaling an 8% probability of a rate cut to a 2% probably of a rate hike next Monday.


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Interestingly, Australia’s one-year inflation swap rates hardly budged. The securities, which exchange fixed payments for returns equivalent to Australia’s CPI over the specified duration, have been in free-fall since mid-to-late April (right around the time we introduced our Deflating the Inflation thesis). The short-to-intermediate-term slope of this market is in unison with our call that the intermediate-term peak of commodity prices is in the rear-view mirror, which should help converge Australia’s headline CPI towards its core CPI rate at -90bps below.


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Perhaps the most important driving force behind the muted reaction in Australia’s inflation swaps market is a glaring lack of consumer demand, which may force Aussie retailers and service providers to discount aggressively in order to sell-through product.


Anecdotally, Australia’s second-largest department store chain, David Jones Ltd., cut 2H earnings guidance to -12% from +5% just two months ago. Our daily grind through Australia’s economic data suggests this micro-level activity is both pervasive and supported by the top-down trend we’re seeing across the Australian corporate sector. A recent quarterly Deloitte survey of 100 CEOs of large, listed enterprises found that only 23% of respondents were positive about the financial outlook for their company – the lowest level since the survey began in 2009 and a near -50% decline from 1Q11. Moreover, Australian deposit-to-loan ratios (a gauge of corporate willingness to invest) at 1.25x are at the highest levels since the thralls of the financial crisis, according to a recent East & Partners study.


We Wouldn’t Want to be Glenn Stevens Right About Now - 4


The widespread bearish sentiment in the Australian corporate sector is largely driven by a weak Australian consumer. Since mid-to-late 2009, Australian consumer confidence and retail sales have made a series of lower-highs and we see further downside over the long-term TAIL. This is driven by a weakness in Australia’s residential real estate market, which, in turn, drives Australia’s household savings rate to new highs (the current 11.5% reading is just -10bps below a 25-year peak). We would expect to see this trend continue over the long-term TAIL absent any material easing in monetary policy. We are not alone in this regard; a recent National Australian Bank residential property price index designed to predict home value values on a one-year forward basis showed a -1.4% decline in the 12 months from 2Q11 (vs. +0.6% in the 12 months from 1Q11).


We Wouldn’t Want to be Glenn Stevens Right About Now - 5


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Some key metrics to consider regarding Australia’s property market: 

  • Nearly 2/3rds of Australian citizens own homes (population = 22.5 million);
  • Roughly 90% of encumbered households have variable-rate mortgages (rate hikes are incredibly painful);
  • At 155% of disposable incomes, Australian households are more +16.5% more levered than U.S. households were just prior to the financial crisis (133%);
  • Australia has the most unaffordable housing in the English speaking world, according to a January Demographia survey (6.1x gross annual household income vs. 3x in the U.S.); and
  • A recent survey confirms the Demographia survey results: the median house price in Australia ($503k in May) is nearly 3x that of the U.S. ($184k in June). 

Judging by this data snapshot, which shows an over-levered consumer facing exorbitant housing prices, it should come as no surprise to see that demand for mortgages in Australia has plummeted to the lowest levels ever in May (+6.2% YoY). Ever, as they say, is a long-time. Moreover, a pickup in mortgage delinquency rates, which hit a record high of 1.79% in 1Q11 according to Fitch Ratings, should put incremental pressure on Australia’s banking system at large and may slow credit growth to other parts of the economy in the event of a systemic buildup in reserves. It’s worth noting that mortgage debt represents 59% of total Aussie bank credit.


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Oddly enough, Australia’s unemployment rate has trended down on both an intermediate-term and long-term perspective and remains just +10bps above its post-crisis low. Additionally, a long-term investment boom driven by the mining industry should continue to exert downward pressure on Australia’s unemployment rate. On the flip side, robust RBA expectations for the long-term TAIL of Australia’s labor market need to be tempered, as we strongly believe Prime Minister Julia Gillard’s carbon tax legislation will slow the rate of investment in this sector – widely noted to be the only beacon of light in Australia’s labor market. The other three main labor market sectors (manufacturing, services, and construction) continue to show material signs of weakness.


We Wouldn’t Want to be Glenn Stevens Right About Now - 8


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Should Australia’s labor market weaken incrementally, we feel Australian economic growth could be at an even greater risk.  As well, we think that Glenn Stevens could shock the Australian economy into a pronounced economic downturn by looking through the current slowdown and hiking rates within the next few months. He could also choose to ease consumer fears regarding additional tightening and provide much-welcome support to Australia’s ailing retail sector and housing market by cutting rates. Either way, we are comfortable shorting the Aussie dollar at this price.


Darius Dale


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Credibility of Aug. 2 default deadline under fire


Solid quarter and guidance. Resumption of guidance probably mean its conservative. 



"Our results for the second quarter reflect continued positive momentum in our business. The improvements during the quarter were broad-based, as all three operating regions posted year-over-year EBITDA gains, and operating margins in our wholly-owned business rose by 240 basis points. We were especially pleased with the continued strong performance of our Midwest and South properties, which reported a 19% EBITDA gain for the region's third consecutive quarter of growth."

- Keith Smith, President and Chief Executive Officer of Boyd Gaming




  • "Our Las Vegas Locals segment....results reflect stable business volumes and effective cost-control measures, as our EBITDA margin rose 140 basis points over the prior-year period."
  • "Net revenue growth in our downtown operations was almost entirely offset by significantly higher fuel costs at our Hawaiian charter service."
  • "In our Midwest and South region...operating results were impacted by the flood-related closure of Sam's Town Tunica for 25 days in May; however, all five other properties in the region reported EBITDA growth in the quarter. EBITDA margin for the region improved by 370 basis points. We saw particularly strong growth at Treasure Chest, Delta Downs and Par-A-Dice."
  • "Borgata continued to outperform the market despite heightened regional competition, boosting its market share by 80 basis points. The property also posted increases in non-gaming revenue, primarily from improved hotel ADRs and occupancy. These gains, however, were offset by increased promotional expense."
  • "The Company is in the final stages of due diligence related to its acquisition of the IP Casino Resort Spa in Biloxi, Mississippi, and expects to complete the process by August 4. Assuming this process is completed satisfactorily, we will pay a $10 million non-refundable deposit to the sellers on this date. We expect to close this transaction early in the fourth quarter."


  • Believe that strengthening trends on the Strip will begin to help their locals business and they are beginning to see that happen
  • Sale of Dania Jai Lai: Process continues to move forward and is scheduled to close in late September
  • They are confident that they can increase IP's earnings potential once they fold it into BYD's operation
  • Focused on finding more growth opportunities
  • Las Vegas locals business: Orleans posted 7% EBITDA growth on higher revenue.  Multiple properties recorded YoY gains. Growth in convention and meeting business increased more than 20% and they expect that run rate to continue. Promotional environment remains elevated but they feel like they have the right strategy.  Feel that locals business has returned to YoY growth.
  • Downtown: If not for much higher fuel costs, EBITDA would have been up 8%.  Starting in September, they will convert to a Boeing 767, making their business more competitive and increasing capacity by 12% for fly-in business.
  • Midwest and South: Strongest margins since 1Q09. Sam's Tunica returned to pre-flood levels of business in July but forward bookings are weak.
    • IP will create substantial cross marketing opportunities
  • Increased promotional spending at Borgata in response to elevated competition for customers. 
  • Share based comp was $2.1MM
  • Expect 3Q interest expense to decrease $5MM sequentially due to expiration of swaps
  • 3Q Guidance:
    • Wholly Owned EBITDA (incl. corp exp):  $65-70MM
    • Borgata EBITDA:  $52-55MM
    • EPS:  $0.00-$0.03


  • Las Vegas Locals: Orleans has been a standout for 3Q's in a row.  Rest of the year, they still expect increases in results despite harder comps.
  • They don't have a lot of room to cut expenses but as revenue recovers they should have really good flow through
  • Treasure Chest: continued to expand operating hours where they are now opened 24 hours on weekends and longer hours mid week.  New Orleans market never got hit as hard as other areas and has therefore improved faster.
  • Lake Charles has benefited from smart marketing to Texas. Their unrated play has picked up.
  • Balance sheet: $330MM maturity of their non-extending R/C and IP acquisition expense. Sources of cash: $350MM of availability of the extending portion of the facility, $80MM of non-cage cash available, Dania sale: $80MM of proceeds upon closing.  So that leaves them with $250-300MM of financing that they need to do - sometime before 1Q2012.
  • The $1.1MM of expenses related to Tunica is the deductible plus some additional expenses - that was added back in the adjusted EBITDA calculation
  • Increased promotional activity at Borgata?
    • Have continued to see elevated promotional environment over the summer that they have seen over the last few quarters.  By 3Q they will cycle through the PA table game addition comps.
    • Feel like their results are pretty good given the elevated competition
  • Dania: Received a non-refundable $5MM deposit. Buyer is spending a lot of money preparing to close on the acquisition. Feel like the buyer is showing every indication of intending to close.  The buyer does have the option to extend closing by 60 days under certain conditions.
  • Not commenting on revenue growth in the Las Vegas locals market but do think that results will increase in the 2H.  Flow through on revenue increases - 1% increase in revenue = 2% increase in EBITDA
  • Summer is the peak season along the gulf coast for hotel occupancy and visitation, but the seasonality isn't huge.
  • Capex:
    • 2Q: $12.5MM (including $6MM at BYD and 7MM at Borgata)
    • They are consistently underspending their capex budget - run rate of $15MM in 3Q and 4Q
  • Promotional environment in locals LV market. They are using a lot mailers. Have stayed away from big ticket /broad based promotions as they tend to have a lower ROI
  • Echelon site?
    • Continue to monitor the recovery of the Strip, but there are no current thoughts or conversations to commence construction there. It is important to have a site on the Strip for them at some point in the future.
  • Have not seen any easing of promotional spending in locals LV since Stations re-emerged from bankruptcy
  • Their visitation in Vegas is healthy but spend per visit is down. They don't need to increase FTE's - just maybe increase hours.
  • Cost of charter service increased $1MM YoY and will likely have a similar increase YoY in the 3rd quarter
  • Spend per visit trends in the LV locals market - they have seen improvements in the top two tier segments of their database across all regions.
  • Share losses in Nevada are largely due to promotional expenditures in their opinion.
  • IP strategy: they are looking for acquisitions that are a good fit, help them to diversify, have a top competitive position, and are accretive and provide a good return.  They are agnostic of future geography outside of the mentioned criteria above.
  • Proposed project in Bossier City- challenging market to consider additional capacity
  • Room renovation at Borgata: Includes all the rooms at the original hotel completed from fall of this year through spring of next year to be completed before Revel opens. It's a comprehensive room overhaul. There shouldn't be a lot of disruption.


The commodities we follow in our commodity monitor, on average, went higher over the last week although the most important items were flat-ish. 


A stronger dollar would do a lot to relieve cost pressure for food, beverage, and restaurant companies.  This past week, however, saw the majority of names move higher.  Specifically, Sugar, Chicken Breast, Rice, Pork and Beef moved higher. 


The table below details the price action in commodities.







Coffee continued its slide downward this week, declining -1.6% following a -8.9% slide last week.  News emerging that Brazil, the world’s largest producer of the commodity, may reach a record level next season on favorable climate conditions are helping ease supply concerns.  Further supply increases are likely necessary to bring the price of coffee down to more “normal” levels; growing demand from international markets is catching investors’ attention.  Countries like Vietnam, Brazil, and Colombia are seeing increasing domestic consumption.


The coffee concepts in the US are seeing tremendous growth and DNKN’s IPO is a sign of that.  If coffee costs were to come down from here to more normalized levels, it would be an intermediate term positive for SBUX, PEET, DNKN, GMCR, CBOU, and THI.  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:  While it seems that price may have been “unusual” to management teams in May, it is taking quite a while for prices to adjust, making these levels less and less unusual.  New coffee consumers are entering the market place and a “new normal”, albeit likely lower than April’s peak, may be reached.
  • 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 roughly $2.50.  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 higher prices to come.





Cheese prices are sky-high at the moment and caused DPZ management to raise guidance for its full year 2011 food basket to 4.5%-6% from 3%-5% yesterday.  We continue to believe that others (like CAKE) will have to follow suit.  Below is a selection of comments from management teams pertaining to cheese prices from recent earnings calls.




  • DPZ (7.26.11): “Given higher than originally anticipated cheese prices, we currently expect our overall market basket for 2011 will increase by 4.5% to 6% over 2010 levels. This was up from our previously communicated range of 3% to 5%.” Hedgeye: Last week we highlighted the fact that DPZ’s last earnings call took place during a trough in cheese prices and we expected a change in tone from the commentary in early May.  CAKE is likely, in our view, to make the same transition in tone at some point this year.
  • TXHR (5.2.11): “We've also got a lot of flow in the dairy markets, in cheese, so there's other things beyond produce that do move around throughout the year.”  Hedgeye: In 1Q09, TXRH called out favorable beef and cheese prices as being primary drivers of cost of sales being down 126 bps in the quarter.  We think it is highly likely that cheese will be a contributor to a cost of sales increase in 2Q11.




Corn prices are continuing to trade largely sideways since mid-July despite Goldman cutting its forecast for U.S. corn production and highlighting “upside risks” in price .  Higher corn prices would support higher protein costs.  At the same time, however, it is worth noting that the increased number of cattle being slaughtered due to the increased costs of maintaining cattle in the current drought that is marring much of the country’s farmland may also decrease demand for corn prices.  Below are two comments on corn prices pertaining to corn.  CMG has a contract on corn and MCD is seeing strong enough comps that it was able to maintain its commodity basket inflation guidance of 4-4.5% in the U.S. for the year.





  • 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: MCD is driving top-line trends so well that commodity cost concerns are being pushed aside.  Additionally, the stronger sales of the higher-margin beverage product helps offset any inflationary pressure from other COGS.



Howard Penney

Managing Director


Rory Green


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