"It's never too late to give up our prejudices."
-Henry David Thoreau
Shorting pullbacks in a market that continues to make higher highs and higher lows is not a strategy that I subscribe to. Selling high and buying low, however, as revolutionary as that might sound, is...
The prejudices that have been born out of levered long investors being pulverized in the last 18 months are a real fear factor in global equity markets. This is the behavioral side of finance that even the "smartest" of the "smart" crowd on Wall Street cannot avoid. However, "it's never too late to give up our prejudices."
As one of our sharper Boston-based clients likes to say, "overbought" is as overbought does. Did I make sales when I thought we we're overbought? For sure. That's what I do. But what is it that you do?
Do your prejudices align your style with buying high in an effort to, as CNBC's Fast Money used to say, "Sell Higha!"? Or are those your bosses' prejudices? Or are they neither, and simply something that's mandated by a rigid investment strategy that was well served for a market that went straight up for the 25 years prior to 2007 in the face of interest rates going straight down?
With this backdrop of stylistic investing stagnation, The New Reality is that there are plenty of investors in 2009 who are capitalizing on consensus and absolutely crushing it. As my Partner, "Big Alberta", Daryl Jones likes to say, "now is the time to crush, or be crushed."
In my career I don't think I have ever heard such a binary line of feedback from the investors in our exclusive network. People are glowingly happy about their YTD performance, or outright depressed.
The Great Depression has indeed found its way into the marketplace in 2009, but that is very much a unique emotional prejudice that has been the direct output of people pressing the consensus bear short case that we had been making from late 2007 until late 2008. I certainly don't consider myself genius for having understood why this market would turn - for anyone who was allowed to be objective (both on the way down, and now on the way up), the facts changing have been crystal clear.
So what about that pullback that everyone seems to be waiting on? Don't you find it a tad ironic that everyone is waiting for the same catalyst? This morning's Institutional Investor sentiment survey had Bears climb right back up the consensus tree to 34% versus 31.5% last week, and only 41% of investors in the survey will actually admit they are bullish. The numbers don't lie; people getting short squeezed do.
The SP500 has provided plenty a pullback over the course of the last 4 trading days. After all, it has been down 3 out of the last 4 days! Within the construct of all my global macro factors pointing to positive price momentum across both immediate and intermediate term durations, what else do I want to see here? A calamity like October/November of 2008? Sure, in hindsight, don't we all. Those days are long gone guys - let's get with the program here.
In Monday's Early Look, I outlined having sold the number of long positions in our virtual portfolio down to 17 (meaning I sold into Friday's closing strength of the SP500 at 929). By the time we saw yesterday's intraday low of 896 on the SP500, we were all staring an expedited -3.5% 48 hour correction. Was that the "pullback" everyone wanted to see, or every time this market pulls back is everyone in the room scared of their own shadows of prejudice? You tell me...
No matter where you go in this 2009 game, people generally are doubtful of the rally. This consensus prejudice continues to provide tremendous opportunity, particularly for those investors who are crushing it year-to-date, and ALLOWED to take the shots when they should be taken. I'm not so enamored with what it is that the "smart" people in this market do anymore - been there, done that. I am going to continue to do the only thing that makes sense to me, and that's keep doing what it is that I do.
Yesterday, with the pullback in hand, I was covering/buying all day. I took my number of long positions back up to 28, and cut my short positions back down to 7 (see our portal for all virtual positions, with time stamps and returns versus entry points, at www.researchedgellc.com <http://www.researchedgellc.com> ). Intraday, I was asked by more than a few people if I really had "conviction" in doing so - conviction is as conviction does...
My immediate term downside support range for the SP500 is 894-903 and my upside resistance line is 938. The plan is that, as prices change, so will my plan. So, for now, I'm taking the shot that my investment process is allowing me to take. In the meantime, may the Shadows of Prejudice support the predictability of this "pullback" that everyone, including me, was waiting for.
Best of luck out there today,
XLY - SPDR Consumer Discretionary-TRADE and TREND remain bullish for XLY. The US economy is showing faint signs the steep plunge in economic activity that began last fall is starting to level off and things are better that toxic. We've been saying since early January that housing will bottom in 2Q09 and that "free money" for the financial system will marginally improve the US economy in 2H09, allowing early cycle stocks to outperform. The XLY is a great way to play the early cycle thesis.
CAF - Morgan Stanley China Fund- A close end fund providing exposure to the Shanghai A share market, we use CAF tactically to ride the wave of returning confidence among domestic Chinese investors fed by the stimulus package. To date the Chinese have shown leadership and a proactive response to the global recession, and now their number one priority is to offset contracting external demand with domestic growth.
EWD - iShares Sweden-We bought Sweden on 5/11 with the etf down on the day and as a hedge against our Swiss short position. Sweden is up a healthy 16.2% YTD and has bullish fundamentals. The country issued a large stimulus package to combat its economic downturn and the central bank has effectively used interest rate cuts to manage its economy. Sweden's sovereign debt holds a strong AAA rating despite Swedish banks being primary lenders to the Baltic states. We expect Sweden to benefit from export demand as global economies heat up.
XLK - SPDR Technology - Technology looks positive on a TRADE and TREND basis. Fundamentally, the sector has shown signs of stabilization over the last eight weeks. As the world demand environment becomes more predictable, M&A should pick up given cash rich balance sheets in this sector (and the game changing ORCL-JAVA deal). The other big potential catalyst is that Technology benefits from various stimulus packages throughout the globe - from China to USA. Technology will benefit from direct and indirect investments.
XLV - SPDR Healthcare-Healthcare looks positive from a TRADE and TREND duration. We've been on the sidelines for the last few months, but bought XLV on a down day on 5/11 to get long the safety trade.
VXX - iPath VIX- The VIX is inversely correlated to the performance of US stock markets. For a TRADE we bought some of the Street's emotion on 5/4, getting long their fear of being squeezed.
TIP - iShares TIPS- The iShares etf, TIP, which is 90% invested in the inflation protected sector of the US Treasury Market currently offers a compelling yield on TTM basis of 5.89%. We believe that future inflation expectations are currently mispriced and that TIPS are a compelling way to own yield on an inflation protected basis, especially in the context of our re-flation thesis.
GLD - SPDR Gold-We bought more gold on 5/5. The inflation protection is what we're long here looking ahead 6-9 months. In the intermediate term, we like the safety trade too.
EWJ - iShares Japan -We re-shorted the Japanese equity market via EWJ on 5/6. This is a tactical short; we expect the market there to pull back when reality sinks in over the coming weeks. Japan has experienced major GDP contraction-the government cut its forecast for the fiscal year to decline 3.3%, and we see no catalyst for growth to return this year. We believe the BOJ's program to provide $10 Billion in loans to repair banks' capital ratios and a plan to combat rising yields by buying treasuries are at best a "band aid".
EWW - iShares Mexico- We're short Mexico due in part to the media's manic Swine flu fear. The etf was up 7% on 5/4, giving us a great entry point. The country's dependence on export revenues is decidedly bearish due to volatility of crude prices and when considering that the country's main oil producer, PEMEX, has substantial debt to pay down and its production capacity has declined since 2004. Additionally, the potential geo-political risks associated with the burgeoning power of regional drug lords signals that the country's economy is under serious duress.
DIA - Diamonds Trust- We shorted the Dow on 5/4 for a TRADE. Everything has a time and price.
IFN -The India Fund-We have had a consistently negative bias on Indian equities since we launched the firm early last year. We believe the growth story of "Chindia" is dead. We contest that the Indian population, grappling with rampant poverty, a class divide, and poor health and education services, will not be able to sustain internal consumption levels sufficient to meet targeted growth level. Other negative trends we've followed include: the reversal of foreign investment, the decrease in equity issuance, and a massive national deficit.
LQD - iShares Corporate Bonds- Corporate bonds have had a huge move off their 2008 lows and we expect with the eventual rising of interest rates in the back half of 2009 that bonds will give some of that move back. Moody's estimates US corporate bond default rates to climb to 15.1% in 2009, up from a previous 2009 estimate of 10.4%.
EWL - iShares Switzerland - We believe the country offers a good opportunity to get in on the short side of Western Europe, and in particular European financials. Switzerland has nearly run out of room to cut its interest rate and due to the country's reliance on the financial sector is in a favorable trading range. Increasingly Swiss banks are being forced by governments to reveal their customers, thereby reducing the incentive of Switzerland as a tax-free haven.
"It's never too late to give up our prejudices."
Some apparel licenses will prove massively unstable in '09 as licensees pull back on investing in content. Some will miss minimums, and will lose business that some currently think is a lock.
Here's an issue that people are not focusing on, but should be - the risk associated with stability in cash flows from licensing streams. The apparel industry is riddled with examples whereby content owners license out their brand to others that have more expertise in a specific product area or consumer segment. Standard royalty agreements are usually in the 6-10% range, net of costs allocated by corporate. In other words, what is a smallish revenue event translates to a meaningful EBIT event given 100% incremental margin. With zero capital at risk, such arrangements are almost always ROIC-enhancing.
I have a high degree of confidence that we are entering a phase of the cycle where these licensing relationships will be strained meaningfully. We'd all be irresponsible not to consider the strategic implications.
Think about it like this... Let's say you are a mid-size company whose EBIT is derived evenly between your own content and content you license from other companies. For the past 7 years, the industry has had every bit of wind at its back (import quota changes, FX, input cost deflation, strong consumer) such that everyone made money - even the marginal players. Now we're in a multi-year period where the opposite is a reality, and many mid-tier brands will go away. So now your top line is rolling, you've underinvested in your brands, flowed through too much FX and sourcing benefit to your bottom line instead of plowing back into your model. So now what? You're probably cutting costs reactively and irresponsibly to keep your head above water. Do you cut costs out of your own content? Or from what you were allocating toward another company's content that you licensed and ultimately will return to them? I'd challenge anyone to find me a company that would opt to damage its own content over another's.
CEOs of companies that license a meaningful proportion of their EBIT (PVH, GES, ICON, to name a few) will argue that there are fixed amounts that partners need to contractually invest each year, which is controlled in part by the company owning the brand. Yes, there are usually fixed dollar amounts or percentages that are required for reinvestment, but that ALL leave plenty of room for unhealthy behavior on the part of the licensee. Remember when Jones Apparel Group said that its Lauren, Ralph, and Polo Jeans business was fine and was 'locked up' for years? 'Nuff said. DCFs don't matter when a business segment you have in your model suddenly ceases to exist.
All it takes is some bad investments (or lack thereof) and a couple of quarters of missed minimums, and the content owners could usually take back the business at will.
The table below shows the percent of EBIT for some major brands derived from licensing. Part There will be some big winners and big losers beginning in '09 folks...
Keith pings us with tickers each night that are standouts in his trade factor models. Tonight he said, "CROX looks awesome ... $2.27 TRADE support." That's the first time I've heard him use the word 'awesome' in months.
At $2.58 we're looking at an EV of $187mm. Yes, this has been a triple over the past two months. But I still find a major problem poking holes in my logic that the new CEO (or a strategic buyer who scoops up this company) could take CROX back to its roots, and takes the top line from the $847mm peak down to a core of $400mm and run at a 10% margin (I can defend this rate six ways til Sunday). That suggests about $43mm in EBITDA. With no store openings, Crocs can sustain itself on $10-15mm/yr in capex - so we're looking at about $25-$30mm in free cash. Not bad for 7x free cash with a call option on monetizing the Crocs brand above and beyond the current consensus view (or lack thereof).
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Let the debate begin on WRC. The company beat the Street by $0.27 and our model by $0.32. The quality is not what headline suggests, but a beat is a beat, so I won't ignore that. But pulling forward $25mm in revenue from 2Q while printing a massive 14% decline in SG&A has its clear leverage pressure points. This says nothing about whether WRC SHOULD cut SG&A to this magnitude. The fact is, it did. The $30mm decline in revs y/y was almost entirely offset by a $25mm decline in SG&A dollars. Yes, WRC has big Int'l exposure (i.e. FX helped SG&A), but it's so rare to see such variability in SG&A. The sustainability here and impact '10 will be THE question (i.e. is mgmt cutting off the third leg of a bar stool?). This smells punk to me.
This name is setting up as a nice 'whack-a-mole.' Stay tuned....
On the bull side, if you like a wholesaler that is transforming into a growing retailer, driven by aggressive square footage growth and the associated mix benefit from high direct-to-consumer operating margins (20% Four Wall for CK retail) while real-estate costs serve as a tailwind, then WRC should continue to work for a while. But, watch out for the very first instance that the rate of store growth slows and overall margin growth trends reverse.
MAJOR CALL OUTS
- Same store sales are slowing (meaningfully) for CK retail:
- o April: -4%
- o 1Q09: +5%
- o 4Q08: +12% (+17% December)
- o 3Q08: +13%
- o 2Q08: +20%
- o 1Q08: +11%
- Raising square footage growth from 20% to 24% for the year. This looks like a classic case of opening stores to drive same store sales to keep overall momentum alive. You can't bet against this for now, but look out when new store growth slows.
- Spent some time discussing a retail strategy for CK accessories. Clearly another lever here to drive DTC growth. Accessories currently has one free standing retail location and the total division is currently producing $100mm. This was the first mention of an opportunity to double the business over the next 3 years, driven primarily by square footage growth.
- CEO quotes on store growth: ""If we could do more we would", "current softness in comps is a momentary aberration", we are pursuing "aggressive growth" in retail
- Despite retail square footage going higher, Capex is going lower. Took Capex down to $35mm from just under $40mm. A nice positive.
- Total SG&A dollars now guided to down $100mm year over year. This is a combination of the $70mm in cost cuts plus the benefit of a larger than originally expected F/X impact. The specificity around cost-cutting on the part of management was light. That's surprising given that we're only talking about a $715mm base in total SG&A for WRC.
- Warehouse Clubs saved the day
- Approximately $25mm in sportswear shipments were pushed into Q1 from Q2 at an above average operating margin. The impact added 5% to total revenues and approximately $0.06 to the quarter (assuming an above avg. 16% operating margin for this piece of business).
- CK intimates also saved by shipment to the clubs at an above average margin.
Research Edge Position: Long Chinese Equities via CAF
China's exports declined over 22% year-over-year in April, a sequential decline from March, significantly worse than consensus estimates with shipments to the EU and the US off by 24% and 17% respectively. While the external demand picture remains grim, the internal demand picture continues to demonstrate strength in the wake of Beijing's stimulus transfusion. Key data point takeaways released in recent days that underscore this are:
- Motor Vehicle sales exceeded 1.15 million in April, a 25% Y/Y increase
- Urban Fixed Investments up 30.5% Y/Y for April
- Housing sales up 35.4% in the first 4 months of 09 Y/Y
- Iron Ore imports up 33% Y/Y to 57 million metric tons
Tonight Industrial Output numbers will be released by the National Bureau of Statistics, with consensus estimates hovering at 9% Y/Y. Any upside surprise in output could well put fire in the belly of China bulls looking for final confirmation that the demand story here is real, while Retail Sales data slated for this evening could provide assurance that that the ox is hungry for more than just iron ore and scrap copper. As we said yesterday, electronics exporters have already seen an uptick in mainland order flow as rural Chinese shoppers take advantage of government rebates and we will look for confirmation that the cash register is ringing in coastal cities as well.
We are long CAF and will be holding it into tonight's news. All data points lead us to believe that the momentum of China's internal demand growth is accelerating.
My first job on the buy side was as a US Retail analyst. That was 9 years ago, and I think my boss gave me that group because it's the easiest one to analyze - I'm one of them Canadian hockey players, eh!
I started trading my own US Consumer "carve-out" of the fund within a few years, and effectively had to learn the art of job stability via not losing money. Losing money in the hedge fund business generally equates to losing one's job - as it should.
Making money on the long side isn't that hard to do. Not getting squeezed on the short side is. If the chart below had an audio clip, it would have a massive sucking sound - from now on I am going to refer to it as The Suckerpool Chart (this one will be really hard for Cramer to say is his - he hasn't used Squeezy yet either).
If you think being short the US Consumer Discretionary sector is a unique thought, think again. This sector, quantified, has the highest bottoms up short interest in the US market. It also now sports none other than Meredith Whitney as the latest doomsayer (yesterday she said short the group on CNBC). I thought she was a bank analyst? Maybe she's moving from the MEGA squeeze in her stocks on over to this one - who knows - but now she's in my sandbox this game probably won't end the way she thinks.
I sold my XLY (Consumer Discretionary ETF) on 4/29/09 at $23.18, so I haven't had to deal with the stresses associated with this sector's recent week of underperformance. Today, I am buying it back.
The Pain Trade that remains in this market is one that's really been a great story in 2009 - squeezing the US Consumer Depressionista shorts. Are they still out there? You tell me... how many people in your investment meetings are ragingly bullish and "long of" US Consumer Discretionary stocks?
I have painted the lines of support (green) and resistance (red) in The Suckerpool Chart below.
Keith R. McCullough
Chief Executive Officer