“If you can’t explain it simply, you don’t understand it well enough”
– Albert Einstein
For some reason, finance and science maintain a rather unique fascination with generating overly complicated and confounding verbiage to describe fairly straightforward and pedestrian concepts. In my 30 years, I have had the lamentable pleasure of being a professional in both vocations.
Before joining HEDGEYE, I was a molecular biophysicist. I’m still not sure I can tell you exactly what that is, but it sure sounds impressive. I’ve also been a dishwasher, business owner, carpenter, physiologist, bartender, Ph.D researcher, industrial sheet metalist, and successful self-taught trader. Wandering philanderer? I like to think of it as Generation Y’s version of a renaissance man.
Across disciplines, many times a process that, superficially, appears complex is really only the summation of a series of simple questions asked and answered. The trick, of course, is in asking the right questions and then having the ability to successfully source the correct data as inputs for the model.
In finance and science, it just so happens that the canonical blueprint for increasing scarcity values calls for the addition of unnecessary technical jargon and intentional obfuscation of the details around the process in a way that makes the output appear overtly complex and thus, through the trappings of behavioral psychology, more desirable.
So, as the edifice of Wall street 1.0 has continued to implode under the weight of institutionalized, levered conventions of its own creation, on the healthcare research side, we’ve been working to develop an investment research process that successfully functions outside of the legacy construct of management one-on-one’s, recycled expert opinion, and valuation-in-isolation and intuition driven decision making.
At the heart of the HEALTHCARE MACRO modeling effort has been the analysis and integration of government data sets which have proven effective in helping us create a quantitative, independent, and thus far, successful process for tracking real-time consumption across the health economy broadly and major sub-industries specifically. Longer-term, healthcare consumption growth continues to be defined by domestic demographic trends.
From a macro level, understanding how this approach functions from a practical investment research perspective can be explained fairly simply. Broadly speaking, the consumption curve for healthcare services across the age continuum is fairly static with elastic demand occurring largely at the margin. Given fixed census trends, if one is able to determine per capita consumption by age for a particular procedure or service type, a reasonable estimate for the underlying growth trend can be derived.
Having a quantifiably justified estimate for underlying organic growth, finding higher frequency data sets that accurately reflect real-time demand and solving for the shorter-term impacts of larger, more acute factors such as employment/insurance status makes it possible to both identify and forecast cyclical growth inflections as well. Conviction is found where the demographic, per capita consumption by age, and the higher frequency macro data function to drive company model inputs that back test with strong correlations across durations.
Taking a TAIL perspective on the healthcare sector, as an example, let’s take a short walk down demography lane and examine the consequences of the existent, secular domestic demographic shift and some of the resulting longer-term investing implications.
Given that the consumption curve for healthcare services across age buckets remains relatively fixed, the glacial movement of U.S. demographic trends holds specific consequences both for healthcare and the larger economy broadly. Therefore, it is important to understand that the period of greatest acceleration in per capita healthcare consumption comes as people age into their 50’s. Equally important is the fact that this 50-64 year old subset is covered, in large part, by high margin, commercial insurance.
The largest acceleration in medical consumption in combination with high margin insurance, places the 50-64 year old demographic as the heart, and profit center, of the health economy. This demographic is now in a secular decline (although the continued acceleration in employment for this age bucket remains a near-term positive for healthcare consumption). In fact, extending current census trends and per capita healthcare consumption by age out over the coming decades reveals a secular bear market for healthcare that won’t see its trough until 2024!
This trend has definite and specific consequences for the hospital industry as well. With roughly 30 cents of every healthcare dollar flowing through the hospitals, the industry sits at the heart of the healthcare economy and is inextricably beholden to meaningful shifts in utilization and service consumption growth.
At present, the current demographic setup is one which will see the 45-64 year old age group graduate into Medicare at a faster rate than those underneath can fill the void. In other words, the spread between those aged 45-65 and those aged 65-85 will reach its narrowest point in 2011 before embarking on a protracted expansion where hospital margins will face a secular decline as negative margin Medicare volumes grow faster than commercial admissions.
In this scenario, we continue to believe high-tech, med-tech remains the relative loser as hospitals focus cost initiatives across controllable supply expenses. ZMH remains our favorite long-term short in the space.
The outlook isn’t completely dismal, however. The 30-40 year old demographic will continue to accelerate for the better part of the next decade. Here, women’s health and companies levered to birth volumes remain favorably positioned to benefit from this secular trend. Moreover, women’s health, along with dental and domestic U.S. physician office exposure, continues to sit positively across a number of our strategic TRADE & TREND themes as well.
(Please email for more on our ZMH specific fundamental and demographic work, additional detail on where we’re targeting long exposure, or further detail on how we marry the HEALTHCARE MACRO process with our fundamental, company research.)
As the transparency curtain gets pulled further back on the collective global balance sheet, staring into the mirror of a leveraged overconsumption past will continue to reveal some painful realities. Growth will remain impaired as developed economies deal with structural debt/deficit issues. Beta will continue to auger to the latest centrally planned headline, and government intervention will continue to sponsor market volatility.
And while Euro & Bureau – Crats continue to hold summits and engineer soundbytes in a flagging attempt to placate markets looking for tactical solutions to structural problems, we’ll continue to evolve our own process.
It’s not perfect, but it has worked a lot more than it hasn’t – and it’s repeatable.
Buy Low. Sell High. Repeat. Pretty Simple.
Our immediate-term support and resistance ranges for Gold, Oil (Brent), EUR/USD, Italy’s MIB Index, and the SP500 are now $1, $106.01-107.93, $1.28-1.30, 14,466-15,094, and 1, respectively.
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The preannouncement out of SHLD has set the stage for what we expect to be several negative preannouncements over the coming weeks. Sales are coming in lighter than expected at both Sears and Kmart, but we think that while SHLD has its own challenges (and they are many), it’s not the only retailer recording lighter than expected sales this holiday season. In addition, it adds to our view that price competition in the mid-tier channel is becoming increasingly more aggressive heading in the 1H of F12.
The struggles at SHLD are hardly an overnight development. At the annual shareholders meeting in May, Eddie Lampert (CEO) addressed the need to optimize the company’s real estate/footprint by increasing its allocation to apparel as well
as exploring lease options (e.g. sub-divisions) among other alternatives.
It should come as no surprise then that apparel was a relative outperformer in the company’s QTD results, which were hit particularly hard by weakness in consumer electronics and home appliances – categories in which SHLD has struggled to maintain share. In addition, the company announced it will also be closing stores.
All in, these measures are not the kind of seismic strategic shifts that one would expect in order to turn a retailer with over $40Bn in annual sales and 4,000+ stores from its current downward trajectory of contracting profits. In fact, we think its
just the beginning of more significant actions to come in 2012.
In the meantime, here are a few thoughts on some the broader implications of the SHLD announcement:
- Kmart comps are running down -4.4% QTD reflecting among other things (i.e. weaker consumer electronics and home appliance demand) lower layaway sales. With WMT now offering layaway on toys and electronics for the first time this year, it appears that heightened competition is taking its toll. For perspective, if we assume that half of Kmart’s comp decline was due to a lost layaway sales equating to ~$300mm and we assume a complete shift of these sales over to WMT, it would add roughly 50bps to WMT’s domestic comps in Q4. A notable contribution in light of +2% comp guidance.
- Closing 100-120 Kmart and full-line Sears Stores is a rounding error when considering the company’s 4,000 store base. With the average box size of a Kmart store at 93,000 sq. ft. and Sears at 133,000 sq. ft., competitors of similar size (i.e. JCP at 101,000 and TGT at 134,000 sq. ft.) will likely see additional pressure as it relates to real estate optionality. Less of an issue for TGT, but a key consideration for JCP with Johnson reviewing any and all options in an effort to transform the retailer.
- In addition, with apparel one of the few bright(er) categories for SHLD, we expect the retailer to get more aggressive in attracting branded content as it looks to boost its portfolio. JCP is in the midst of a similar initiative. As such, we expect heightened competition for brands to result in higher acquisition costs. This is not really new news, but incrementally worse on the margin given SHLD’s reliance on apparel performance.
- Reducing inventory by $500-$580mm from peak 2011 levels = more price competition at the mid-tier. Between
Sears and Kmart, SHLD accounts for ~5-8% of the ~$180Bn domestic apparel industry and roughly 15% of the mid-tier segment. While $500mm accounts for less than 1% of the mid-tier, it’s yet another factor that will weigh on prices and margins in the 1H of F12. The reality is that SHLD is not going to get there without promotionally induced sales
With retailers set to report on Holiday sales next week coupled with ICR the following week, we suspect SHLD won’t be the only company in retail preannouncing between now and then.
“The only time I have problems is when I sleep.”
- Tupac Shakur
In Greek mythology, Hypnos is known as the god of sleep. His palace was a dark cave where the sun never shone. The palace itself had no gates or doors, so that he would never be awakened by sounds from doors opening and closing. Unlike Hypnos, global macro markets, especially in these interconnected times, never sleep.
The most noteworthy news overnight, not surprisingly, comes fromEurope. The first Italian bond auction of the week was held this morning and it was, on the margin, successful. Italysold 9 billion euro of 6-month bills at 3.25%, which was dramatic improvement over the last auction on November 25ththat sold at a yield of 6.5%.
As Greek mythology tends to work, Hypnos’ brother was Morpheus, the King of Dreams. So, while you may still be asleep, especially given the holiday shortened week, the paragraph above is not a dream. The Italians actually did have a better than expected bond auction this morning. If there was any disappointment, it was likely in the tranche of 2013 zero coupon Italian debt that was auctioned this morning. The Italians were able to sell only 1.7 billion euro of the maximum allotted 2.5 billion euro.
Certainly though, we need to jot down this auction as a positive data point in our notebooks, as it is a sequential improvement. The true test of whether there is an improved appetite for Italian sovereign debt will occur tomorrow. In tomorrow’s auction, the Italians will attempt to sell up to 8.5 billion euro of 3, 6, and 10-year debt. In theory, if the Long-Term Refinancing Operation, or LTRO, of the ECB is even moderately successful, then tomorrow’s auction should see some improvement over the prior comparable auction.
“In the chart below, we’ve highlighted the ECB liquidity facility going back one year and in the inserted chart going back roughly one month. The key takeaway is that the ECB liquidity facility, which is used by European banks to effectively park money, hit a new all-time high at 411 billion euros this morning and has been increasingly rapidly since the inception of the LTRO just over a week ago. In fact, the day before the LTRO was put into effect, the ECB facility was at 265 billion euro and as of this morning has increased by 146 billion euro, or more than 70% of the incremental liquidity from the LTRO.
So, not only is the LTRO not being used as a bazooka by the European banks, but these banks are parking the borrowed LTRO money with the ECB rather than using it to buy sovereign debt, and thus are experiencing a negative yield on the trade.”
Given the results of the Italian bond auction this morning, there is some evidence the LTRO is being used as the fabled bazooka. Ironically, though, the amount of money parked at the ECB’s liquidity facility increased dramatically overnight to a record of 452 billion euro. This is an increase of 41 billion euro from the prior day. We would caution reading too much into the “successful” Italian bond auction as clearly the risk aversion trade remains in full effect.
In other European news, the prominent Spanish newspaper, Expansion, is indicating that Rajoy may force Spanish banks to cut the valuation of the real estate assets on their books by up to 20%. The fact that Spanish banks still need to write down real estate assets on their balance sheets should not be terrible surprising to anyone.
Spanish home ownership rates are above 80% on the back of cheap long-term mortgages, often up to 40 and 50 years. As well, the government encouraged home ownership by making 15% of mortgage payments a tax deduction. The Spanish real estate bubble makes Phoenix and Florida housing look like a value investment.
Unfortunately, the Spanish real estate market isn’t likely to improve anytime soon. Specifically, in October, Spanish real estate loans decreased for an18th straight month and were down 43.6% year-over-year. Our long term analysis has shown that demand for mortgages is one of the best predictors for future real estate prices. Therefore a 20% cut in the valuation of real estate assets for Spanish banks seems more than reasonable.
On the domestic front, Bloomberg this morning is predicting that 2012 could be the biggest year for IPOs since 1999. Given the current filings, internet IPOs may raise more than $11.0 billion in the coming year. In the face of heightened volatility and a 2011 that was lackluster in terms of equity offerings, raising only $156 billion in 2011 versus $252 billion, the onslaught of internet offerings seems a bit excessive. Undoubtedly, even Dionysus, the Greek god of partying and excesses, would agree with that.
Keep your head up and your stick on the ice,
Daryl G. Jones
Director of Research
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