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Experts vs Algos

“Why are experts inferior to algorithms?”

-Daniel Kahneman

 

That’s just another great risk management question from the guru of behavioral finance on page 224 of “Thinking, Fast and Slow.” If you don’t have time to read the entire book, definitely take the time to study and consider the implications of Chapter 21, Intuitions vs Formulas. In the last 4.5 years of my time away from a hedge fund desk, I’ve thought a lot about Experts vs Algos.

 

Understandably, algorithms scare people; particularly people who have zero analytical competence in modern math (i.e. 99% of the politicians and central planners running America). This contrasts sharply with the Chinese political leadership where 8 of China’s top 9 political dudes are mathematicians and/or scientists.

 

I started building my own predictive tracking algorithms so that I could attempt to remove the emotion when I hit buy and sell buttons. It helped me so much that we started plugging these predictors into our fundamental Growth and Inflation models for countries. That’s why our intermediate-term forecasts on things like GDP, PPI, etc. are so variant from the Old Wall’s consensus.

 

I’m not saying that what we have built is perfect. However, I am saying it’s better than what I used to use – and a lot of people on Old Wall Street still use what I was taught to use at A) the Keynesian School of Economics and B) the Sell-Side brokerage firms that perpetuate its dogmatic principles.

 

Kahneman’s answer to the aforementioned question is pretty simple. “One reason, which Meehl suspected, is that experts try to be clever, think outside the box, and consider complex combinations of features making their predictions. Complexity may work in the odd case, but more often than not it reduces validity. Simple combinations of features are better.” (page 224)

 

Kahneman goes on to remind us that “humans are incorrigibly inconsistent in making summary judgment of complex information.” And if there is one thing that any of you know about your own team’s investment meetings since late 2007, that’s God’s honest truth.

 

Back to the Global Macro Grind

 

Rather than attempt to handicap who has to chase S&P 1400 into options expiration tomorrow (there’s a massively skewed position in the 1400 strike calls vs puts), I’ll just rattle off what my Algos think on risk ranges, prices, and probabilities vs Experts:

  1. SP500 could easily trade to 1401 inasmuch as it could fall to 1369 – that’s my immediate-term TRADE range
  2. US Equity Volatility (VIX) holds its long-term TAIL line of 14.21 support like a champ; upside to $17.34
  3. US Equity Volume/SKEW signals are at least as bearish as the 1987 signals that started developing in Q1 of 1987
  4. The first 2 of 9 S&P Sectors that have snapped their immediate-term TRADE lines of support (XLE and XLB) did last yr too
  5. Size (as in the risk management factor to describe cap) flashed another bearish signal yesterday (Russell 2000 = -0.82%)
  6. US Basic Materials (XLB) and Small Cap (IWM) stocks have been making lower-highs since peaking YTD on Feb 3rd
  7. US Dollar Index has moved back into a Bullish Formation (bullish on all 3 risk mgt durations – TRADE, TREND, and TAIL)
  8. US Treasury Yields are ripping above their intermediate-term TREND lines of 0.26% (2yr) and 2.03% (10yr), respectively
  9. US Treasury Yield Spread has widened 20bps as the Financials (XLF) have moved to immediate-term TRADE overbought
  10. US Technology (XLK) Sector Study is flashing a grossly immediate-term TRADE overbought signal at $29.97

While it’s tidy to tell ourselves that everything in America is fine, what all of this is really saying is that if Apple (17% of the XLK) and the Financials (up in a straight line in the last 2 days in response to the rallying cry of “success” to a made-up test) stop going up, the SP500 will probably stop going up too, in the immediate-term (3 weeks or less), at 1401.

 

What are the rest of the world’s signals telling us?

  1. Japanese Yen is crashing (yes when a Top 3 world currency drops 10% in a straight line, that’s a crash)
  2. Japanese Equities (like European Equities did around this time last year – pre Sov Debt Crisis) like a crashing currency
  3. Chinese stocks, down for 2 consecutive days (-3.3%) post the US “stress test”, still see Growth Slowing
  4. Indian stocks, down -1.6% overnight, failing at immediate-term TRADE resistance of 18,023 again, don’t like oil up here either
  5. Germany’s DAX melts up to +20% YTD as German bond yield spreads versus US Treasuries widen (bullish for Germany)
  6. Spain’s stock market (IBEX) is flashing a very bearish negative divergence vs Global Equities (down -1.4% YTD)
  7. Spanish bonds, currency (euro), and stocks are now all falling at the same time – clean cut sovereign debt alarm bell ringing
  8. Greece’s stock market would need to close > 771 on the Athex to signal any accomplishment of quantitative support
  9. Israel’s Equity market (TelAviv25) up for the 3rdconsecutive day, holding 1081 support (post Gaza “truce”)
  10. Dr Copper agrees with China on Growth Slowing, failing to close above its long-term TAIL line of $3.98/lb, again

Obviously weaving throughout this Storytelling of “growth is back” (as US GDP Growth gets cut in ½ sequentially vs Q4) are US stock market centric people trying to tell you that Gold falling is a “bullish sign for US stocks” (like they did in FEB and SEP of 2011). My Algos vs Experts on that say God Speed. Bond Yields spiked, momentarily, as US Stocks topped in February of 2011 too.

 

I’ve tried to not get mad at my Algos since 2008. They don’t give me any lip, and they don’t make excuses when they fail. They may have not always made my risk management views popular either. But at the big turns, before big draw-downs in asset prices, they’ve also gotten me out of the way.

 

My immediate-term support and resistance ranges for Gold, Oil (WTIC), US Dollar Index, Japanese Yen, and the SP500 are now $1, $105.02-106.49, $79.79-80.61, $82.71-83.98, and 1, respectively.

 

Best of luck out there today,

KM

 

Keith R. McCullough
Chief Executive Officer

 

Experts vs Algos - 11. IBEX

 

Experts vs Algos - vp 3 15


GALAXY 4Q CONF CALL NOTES

GALAXY 4Q CONF CALL NOTES

 

 

PREPARED REMARKS AND Q&A

  • Infrastructure projects will drive visitation in 2012
  • Sees significant Galaxy Macau margin upside in 2012
  • Still at the beginning of their era in Macau
  • Galaxy Macau premium mass/mass business continues to ramp up
  • Galaxy Macau VIP also ramping up; will take 12-18 months to optimize
  • Reinvesting back into company is better use of funds right now. e.g. 86% ROI at StarWorld 
  • About $100-120MM related to higher than normal hold
  • Remaining capex for Galaxy Macau: $2.4 BN 
  • Galaxy Macau: grind and premium mass segments doing well
  • Galaxy Macau Mass is the main focus
    • Next week will open Pavilion Club; will open new high-limit mass tables
  • $1.2BN cash due to proceeds from RMB bond offering (Balance Sheet: Other Cash Equivalents line)
  • Effective in 2012, interest expense will be reduced due to a change in financing of a City Clubs loan
  • Wages increasing 5-6% in 2012
  • Everyone benefited when Galaxy Macau opened

 

HIGHLIGHTS FROM RELEASE

  • Q4 Group adjusted EBITDA: HK$2.1BN
    • StarWorld Q4 adjusted EBITDA: HK$827MM
    • Galaxy World Q4 adjusted EBITDA: HK$1.2 BN
  • Cash at end of 2011: HK$7.7BN (HK$2 BN restricted cash)
  • 2011 non-recurring items 2011: Galaxy Macau pre-opening expenses: HK$0.8BN; charges from the change in fair value of the derivative under the convertible notes of HK$0.2BN and net loss on buyback of guaranteed notes of HK$0.1BN.
  • 4Q Galaxy Macau
    • VIP turnover: HK$167 BN
    • VIP win: HK$5.5 BN
    • VIP hold: 3.3%
    • Mass drop: HK$5.7 BN
    • Mass win: HK$1.4 BN
    • Mass hold: 24.1%
    • Slot handle: HK$4.3 BN
    • Slot win: HK$269MM
    • Slot hold: 6.3%
  • 4Q StarWorld
    • VIP turnover: HK$175 BN
    • VIP win: HK$5.4 BN
    • VIP hold: 3.1%
    • Mass drop: HK$2.3 BN
    • Mass win: HK$0.5 BN
    • Mass hold: 20.9%
    • Slot handle: HK$1.038 BN
    • Slot win: HK$64 MM
    • Slot hold: 6.1%
  • Debt: HK$11.672 BN


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WEEKLY COMMODITY CHARTBOOK

Despite the stronger dollar over the past week, the commodities that we monitor generally gained with the exception of pork, rice, and coffee. 

 

WEEKLY COMMODITY CHARTBOOK - commod

 

CONSUMER CALLOUT

 

McDonald’s COO, Don Thompson, speaking at the UBS Global Consumer Conference, had the following to say about grocery inflation and its impact on McDonald’s business: “I think the projection for 2012 is for the grocery store prices, the food at home to moderate a little bit in the maybe 4% to 5%, 3% to 4% range and food away from home to be more like 2% to 3%. So that gap is closing but the projections are still for the grocery stores to be a little higher. If that means for us, our back store cost won't increase as much, that's a good thing.” 

 

As our chart below illustrates, the spread between food at home CPI and food away from home CPI has been narrowing over the past four months.  If the trend over the last four months were to continue, assuming the average rate of narrowing since the spread stopped widening, by the end of the second quarter the spread would be closed.  While this is not a foregone conclusion, it is important to note that – on the margin – the gap has been closing and offering less of a competitive advantage to restaurants versus grocery stores.

 

WEEKLY COMMODITY CHARTBOOK - food at home vs food away from home cpi white

 

 

SUPPLY & DEMAND

 

Wheat

 

SUPPLY

 

The USDA’s Wheat Outlook report is projecting world wheat production in ‘11/12 2011/2012 world wheat production is up 1.1 million tons this month to 694.0 million, further raising the historical record. In Australia, 2011/12 production is up 1.2 million tons to 29.5 million this month, and up 1.6 million tons on the previous year’s record.

 

DEMAND

 

Record production and stocks have stimulated trade.  Iran is negotiating grain purchases with Russia, Pakistan, and India using letters of credit denominated in rubles and rupees to bypass Western banking sanctions.  Globally, export forecasts have been increased for countries including Australia, Brazil, Kazakhstan, and the U.S.

 

 

Beef

 

SUPPLY

 

The USDA said that 922k farms raised cattle last year, 13k fewer than in 2010.  The USDA has lowered its forecast for 2012 beef production by 80 million pounds and raised its forecast for fed cattle prices by $2.50/cwt.

 

The Texas AgriLife Extension Service is beginning a statewide educational initiative focusing on rebuilding cattle herds within the state.  Dr. Ron Gill, AgriLife Extension livestock specialist said, “…The historic drought of 2011 dramatically accentuated that trend [declining herd sizes].  The state’s cattle industry and affiliated trade and service companies are the second largest economic driver in the state, bringing in billions of dollars to the state economy. With the cowherd at such a critically low level, Texas will start to lose infrastructure if cow numbers do not increase soon.”

 

The World Agricultural Supply and Demand Estimates from the USDA indicated that beef supplies will shrink further this year and imports will pick up, but not enough to account for lower production and continues strong exports, according to USDA projections.

 

 

DEMAND

 

Beef exports in January were even in volume versus a year ago but increased in value by 14%.  Philip Seng, president of U.S. Meat Export Federation (USMEF), said that “there are opportunities to expand the presence of U.S. red meat by exploring new market niches as well as increasing access with several key trading partners.”

 

 

Chicken

 

SUPPLY

 

Egg sets placements continue to contract at around the same rate, at -5.4% for the six-week moving average, according to the Broiler Hatchery report released by the USDA today. This implies that supply will remain tight as the industry looks for more favorable business conditions before expanding production.

 

WEEKLY COMMODITY CHARTBOOK - egg sets vs wing prices

 

 

RECENT COMPANY COMMENTARY

 

Beef: Most companies are expecting beef cost inflation to be up mid-to-high single digits versus last year

 

TXRH: We expect approximately 8% food inflation in 2012, primarily due to higher beef costs…on the beef side we do have fixed price – pricing arrangements in effect for over 90% of our beef costs in 2012.

 

CBRL: To the continued pressure on ground beef prices and other commodities partly offset by lower average dairy and produce prices, along with benefits from our supply chain initiatives, we expect cost of sales to increase 60 basis points to 80 basis points over 2011 to near 26% in 2012.

 

RUTH: We project 2012 beef inflation to be between 5% and 8%. We currently have purchase agreements for beef representing approximately 30% of our needs through August of 2012, which represents an approximate 7% premium compared to the prior years.

 

CMG:  While we're cautiously optimistic we'll see more reasonable prices in 2012 for avocados, dairy and produce, we expect these benefits will be more than offset by higher costs for our beef, chicken, rice and beans. Beef costs will be especially challenging due to protracted supply shortages, despite recent reductions in grain prices.

 

MCD: As we look at our guidance for 2012, we've built another mid-teens increase for beef, expecting that the dynamics in the marketplaces that we see, and are expecting, will continue.

 

DRI:  U.S. beef production will continue decline though over the next 24 months, placing continued upward pressure on beef prices because of the slow economic recovery hamburger and value oriented beef, cattle beef are in high demand and can be priced accordingly by the packers. At Darden we purchased mainly tenderloins and other premium steakcuts, while we expect pricing for our beef products to increase by 12% our pricing has been tempered by consumers' resistance to record higher retail prices for premium stakes and the resulting shift to value oriented cuts and as you can see beef is approximately 14% of our cost basket … We have 75% of our beef requirements contracted for fiscal 2012 and 40% of the June to December usage under contract for fiscal 2013.

 

SONC: One item to note is that we recently locked in our beef contract for calendar year 2012… given the potential for beef costs going even higher, which there are a lot of reports out there that speculate that could happen, that we chose to go with making this more of a known quantity here, and the idea of having a set price for the next 12 months, we feel like would be good for our business, adds some predictability to the business.

 

 

Coffee: Prices are now down -32% versus last year

 

PEET: We expect 2012 coffee costs to rise 12% instead of last year's 42%.

 

SBUX: We've taken advantage of the recent declines in the C-price to lock in more of our coffee needs for fiscal 2013. We now have six months of our fiscal 2013 requirements secured at costs moderately favorable to 2012.

 

 

Dairy: CAKE, DPZ, PZZA, TXRH and others could benefit from favorable cheese costs this year

 

TXRH: The volatility around that 8% estimate for food cost inflation would really be driven by produce and dairy.  Those are of the biggest components that we float around the market, and that's about 15% to 20% of our total cost of sales.

 

CMG: While we're cautiously optimistic we'll see more reasonable prices in 2012 for avocados, dairy and produce, we expect these benefits will be more than offset by higher costs for our beef, chicken, rice and beans.

 

 

CORRELATION TABLE

 

WEEKLY COMMODITY CHARTBOOK - correl 

 

 

CHARTS

 

 

 

WEEKLY COMMODITY CHARTBOOK - coffee

 

 

 

WEEKLY COMMODITY CHARTBOOK - corn

 

 

 

 

WEEKLY COMMODITY CHARTBOOK - wheat

 

 

 

 

<chart12>

 

 

 

 

WEEKLY COMMODITY CHARTBOOK - live cattle

 

 

 

 

WEEKLY COMMODITY CHARTBOOK - chicken whole breast

 

 

 

 

WEEKLY COMMODITY CHARTBOOK - chicken wings

 

 

 

 

WEEKLY COMMODITY CHARTBOOK - cheese

 

 

 

 

WEEKLY COMMODITY CHARTBOOK - milk

 

 

Howard Penney

 

Managing Director

 

 

 

 

 

Rory Green

 

Analyst

 

 

 

 

 

 

                            


BWLD UPDATE

With Buffalo Wild Wings’ stock up 32.5% year-to-date, our negative research stance heading into the 4Q11 EPS print has definitely left a scar.  We are also not going into hiding because the facts indicate that some important questions need to be answered by Buffalo Wild Wings to sustain its stock price at current levels.  Besides the more specific issues facing the company, the macro environment for restaurant stocks is generally positive – for now.  Here we run through our updated thoughts on the stock.

 

Our view of Buffalo Wild Wings’ 4Q11 results was that, while the top line numbers were impressive, it was disconcerting that margins did not expand despite the fact that elevated wing prices were yet to impact the P&L.  On its own, this fact would likely have been enough to prompt skepticism among investors but – unfortunately for our research call – the 1Q12 to-date (as of 2/7) same-store sales number, at 12.9% at company locations, superseded any margin-related concerns. 

 

The stock has settled in at around $90 and the EV/EBITDA (NTM) multiple has expanded to 10x.  We are less than convinced that this current price level is sustainable over the intermediate term TREND and see significant risk to the downside if the company does not execute to perfection over the next two quarters.  The Street, it seems, shares this view; despite the impressive 1Q guidance and the implied same-store sales trends, FY12 EPS estimates did not move significantly.  Estimates for 1Q12, appropriately, were revised sharply higher but it seems that analysts are waiting to see how the rest of the year plays out (chart1, 2).  Our view is that costs will play a more significant role in 2Q and 3Q than consensus is allowing for. 

 

Here are some points we are currently focused on:

  • The sequential move in comparable-restaurant sales from 8.9% in 4Q11 to 12.9% for the first five weeks of 1Q12 benefitted by 3% from the impact of gift cards and also, we estimate 2-3% of favorable weather impact.  Our estimate for the real current run-rate of comps is 7%.  Gift cards may not have as much of a favorable impact on the full quarter comp versus January’s but we still expect a significant boost from gift cards and weather for 1Q12 comps.
  • The Street obviously gave the company a pass on flat margins in 4Q, despite a stronger-than-expected top line, due to the 12.9% 1Q12 to-date same-store sales number released coincidentally.  4Q11 was a poor quality quarter for BWLD given the lack of flow through on strong comps and the fact that the tax rate was lower than expected.  Unless the company can keep disclosing quarter-to-date comps far in excess of expectations, the lack of leverage in the business model will be a concern for investors.  Without gift card and weather benefits, especially in the event that the broader employment outlook softens the stock price could move lower.  Tougher top line compares are coming in 2Q and 3Q for BWLD and we believe investors will be seeking reassurance from management that the momentum in sales is continuing into April when 1Q EPS is reported (chart 3).
  • We are hearing from some franchisees that sales softened in the second half of February.  Gas prices (up 6% in the two weeks from 2/15) are thought to have been a factor.
  • Chicken prices continue to head higher.  While chicken wings led the way, other cuts are now following; breast, leg, and full bird prices are all gaining as elevated beef prices push food service toward chicken products.  This demand for chicken is a bullish indicator for wing prices.  Additionally, as the processors continue to struggle, supply remains constrained (chart 4).
  • Sanderson's Farm (SAFM) is up 14% over the past month on the improved outlook for chicken prices.  
  • In order to manage inflation and meet EPS expectations, management will likely need to cut costs and/or raise prices.  Both of these strategies could ultimately have a negative impact on the top line.  Cutting G&A costs is not without its risks for a "growth" restaurant company given the likelihood that it might impact revenue growth down the road.  Additionally, as we learned on the 2Q11 EPS earnings call, expanding the concept's geographical reach - a key component of the growth story - requires significant G&A investment.
  • Management mentioned the possibility of acquiring or developing a second concept.  This is generally a huge drain on company resources and can require significant investment.  We would be initially skeptical of this notion but obviously will reserve judgment until such a time that management might disclose more detail.  Our initial concern is founded upon the fact that BWLD is not generating much cash flow (after growth-related expenses).   The company’s net CFFO-to-net income ratio has been barely positive over the last year (chart 5).  If margins contract in 2Q and 3Q, that only heightens our negative view of BWLD acquiring an additional concept; the company would have to lever up to acquire a second concept of significant scale.
  • AT 10x EV/EBITDA, BWLD looks very expensive for a company with a checkered past of inconsistent operating performance.  

BWLD UPDATE - bwld consensus EPS

 

BWLD UPDATE - BWLD EPS chg

 

BWLD UPDATE - bwld pod1

 

BWLD UPDATE - egg sets wing prices

 

BWLD UPDATE - bwld pod3

 

 

 

 

Howard Penney

Managing Director

 

Rory Green

Analyst

 


VRA: Structurally Incapacitated

We don’t like VRA headed into the Q4 print, or coming out of it. It’s next to impossible for us to make a valuation call in this tape. But our model is 20% below Street expectations next year, which pretty much speaks for itself.

 

 

TRADE (3-weeks or Less)

We’re at $0.44 vs. the Street at $0.47E for Q4. We expect the shortfall to come from lower margins despite the likelihood of sales coming in above the upper end of guidance.

  • Current expectations for a rebound in gross margins implies the impact of a timing shift in sourcing costs and opportunistic sale of retired inventory were one-time events and does not appear to reflect the current promotional climate or VRA’s exposure to cotton.

TREND (3-months or More)

Comps have been driven by pattern proliferation and additional category expansion over the last two years and are starting to slow putting greater emphasis on store growth to drive the top-line driving higher costs.

  • Managing the inventory/sales growth spread will remain challenging in the 1H with sales slowing at the same time retailers get increasingly cautious on inventory.
  • Top-line trends are already starting to roll. The top end of Q4 guidance implies a significant deceleration in both the 1yr and 2yr trends. We expect this trend to continue with mid 20%s revenue growth over the last two years slowing to a low-teens rate over the next two as retail and e-commerce growth offsets a decline in wholesale sales.
  • In addition, our sense is that VRA is getting more aggressive with the terms it’s offering wholesale accounts to encourage earlier receipts. This tactic might work to drive sales over the near-term, but it’s not sustainable. Particularly given the profile and size of 25%-50% of VRA’s wholesale accounts, which simply don’t have the capacity to store excess inventory.
  • Perhaps this is already happening. Management addressed concerns about product showing up at Costco on a recent conference call essentially revealing that while they don’t sell directly to Costco, a large wholesale account had flushed excess inventory through the discount channel. There is nothing to keep this from this happening again. It may be through smaller channels (think flash sale sites), but the evidence of over inventoried product inevitably comes to roost.

TAIL (3-years or Less)

VRA risks overextending the brand in pursuit of additional category expansion. At the same time, the company is looking to expand internationally into Japan and double the size of its DC which requires incremental investment.

  • Square footage growth can come, but at a price we think is grossly underappreciated when it comes to VRA’s business model. Unlike the other brands, VRA is sold not through department stores (with the exception of a few Dillard’s locations), but rather through small independent retailers where VRA often drives and accounts for a meaningful percentage of sales at each wholesale account. Its network of 3,400+ small independent retailers is far more sensitive to the competitive threat of company-owned retail stores opening nearby than typical brands that are distributed in department stores that are far less reliant on any one vendor.
  • Despite efforts to expand its product offering (e.g. rolling luggage), VRA is more constrained than the other brands in its ability to drive meaningful category growth limiting store productivity potential. This has been reflected in a material deceleration in comps to HSD with little to suggest a material reacceleration is likely.
  • Over the last three years, SG&A leverage has accounted for 9 pts of margin expansion, which is now likely to shift in the other direction and suggests VRA was over earning in its first year as a public company. We expect this shift to result in a 2pt margin swing as a 1.5pt tailwind turns into a 0.5pt headwind this year (F13). (see table below)
  • Over each of the last two years, VRA has kept Advertising, Marketing and Product Development flat to down. This is the line that accounts for new product initiatives for a brand that’s starved for expansion ideas – not good. We think VRA is going to be forced to take this line higher over the next few years. We are modeling this line up +10% and along with continued growth in selling expense expect SG&A deleverage for the first time in four years.

The stock appears to be baking in the kind of growth that we’d associate with the possibility of another department store partnership. We prefer to value what we see in front of us and that’s a brand challenged to grow with operating margins already over 20%. We are shaking out at $1.55 and $1.61 in EPS for F12 and F13 respectively 20% below Street expectations next year (F13). With the stock trading at 22x and 12.5x consensus F12 EPS and EBITDA estimates, this is not reflected in the stock here at $37. Nor is the structural risk in VRA’s wholesale accounts once it starts rolling out owned retail stores more aggressively.


Casey Flavin

Director

 

VRA: Structurally Incapacitated  - VRA WhslRevDoor Chart

 

VRA: Structurally Incapacitated  - VRA RevsTable

 

VRA: Structurally Incapacitated  - VRA SG A

 

VRA: Structurally Incapacitated  - VRA SIGMA

 


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