This note was originally published at 8am on July 02, 2014 for Hedgeye subscribers.
“Dreams of castles in the air, of getting rich quick, do play a role – at times a dominant one – in determining actual stock prices.”
-Burton G. Malkiel
For the past several days, I’ve been reading a gem of a book recommended by my colleague, Howard Penney. Malkiel’s “A Random Walk Down Wall Street” is a timeless, thought provoking piece that most curious investors would enjoy reading poolside on a beautiful summer day. I certainly did. After all, restaurant research isn’t limited to cheeseburgers and fries. In fact, a large part of our job pertains to understanding both human and market psychology. The castle-in-the-air theory, which concentrates on the psychic values of investors, serves as a constant reminder of this fact.
For those unfamiliar with its origin, the castle-in-the-air theory was popularized by John Maynard Keynes in 1936. While we tend to disagree with Keynes’ and his disciples on a number of economic issues, the notion that stocks trade off of mass psychology is widely appealing. Accordingly, some investors attempt to front run this onslaught of groupthink, not by identifying mispriced stocks, but rather by identifying stocks that are likely to become Wall Street’s next darling. All told, this can be a profitable strategy – until it’s not.
Back to the Global Macro Grind...
We believe we’ve identified one of Wall Street’s current darlings and recently added it to the Hedgeye Best Ideas list as a short. Del Frisco’s Restaurant Group (DFRG) owns and operates three distinctly different high-end steak chains. After coming public in July 2012, the stock has gained over 114%; quite impressive, by any measure. More importantly, however, we believe cheerleading analysts and the subsequent madness of the crowd have propelled the stock during this time. Is it reasonable to call a company whose adjusted EPS declined 7% in 2013 one of the greatest growth stories in the restaurant industry? We think not.
As Malkiel goes on to say:
“Beware of very high multiple stocks in which future growth is already discounted, if growth doesn’t materialize, losses are doubly heavy – both the earnings and the multiples drop.”
The truth is, the company currently screens as one of the most expensive stocks on both a Price-to-Sales and EV-to-EBITDA basis in the casual dining industry. While we’re not insinuating DFRG is the beneficiary of a “get-rich quick speculative binge,” we are confident the stock is severely dislocated from its intrinsic value.
Part of the hype has been driven by the company’s positioning within the restaurant industry. Del Frisco’s caters to the high-end consumer; a cohort that the stock market would suggest is doing quite well. While this may be true, we believe the high-end consumer has been slowing on the margin as inflation in the things that matter (food, energy, rent, etc.) continues to accelerate. Contrary to popular belief, high-end consumers can feel the pinch too and two-year trends at the company’s hallmark concept, Del Frisco’s Double Eagle Steakhouse, would suggest the same.
Admittedly, the Double Eagle Steakhouse, though slowing, is a healthy concept. But it’s only 25% of the overall portfolio. The other 75% consists of a fundamentally broken concept (Sullivan’s) and an unproven growth concept (Grille). Naturally, the Street is discounting an immediate turnaround at Sullivan’s and a flawless rollout of the Grille, neither of which we see materializing. In fact, we continue to expect restaurant level and operating margin deterioration throughout 2014. This has less to do with all-time high beef prices (32.8% of Del Frisco’s 2013 cost of sales) and the recent wave of minimum wage increases (25% of Del Frisco’s restaurants have exposure), than it does with the fact that the company is systematically growing at lower margins and, consequently, returns.
More broadly, there are a number of red flags that the Street is unwilling to acknowledge right now including decelerating same-store sales and traffic trends, declining margins, declining returns, increasing cost pressures, expensive operating leases, peak valuation, positive sentiment and high expectations. We simply refuse to give the company credit for what it has not proven and while we can’t hit on all the minutiae of our thesis in this note, we do have a 67-page slide deck that does precisely that (email email@example.com for more info). In short, our sum-of-the-parts analysis suggests significant downside.
You can delay gravity, but you can’t deny it. Needless to say, we don’t expect this particular castle-in-the-air to stay there much longer.
Our immediate-term Global Macro Risk Ranges are now:
UST 10yr Yield 2.50-2.59%
Brent Oil 111.51-115.43
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TODAY’S S&P 500 SET-UP – July 16, 2014
As we look at today's setup for the S&P 500, the range is 29 points or 0.88% downside to 1956 and 0.59% upside to 1985.
CREDIT/ECONOMIC MARKET LOOK:
MACRO DATA POINTS (Bloomberg Estimates):
WHAT TO WATCH:
COMMODITY/GROWTH EXPECTATION (HEADLINES FROM BLOOMBERG)
The Hedgeye Macro Team
Takeaway: A recent string of ratty growth data out of Singapore calls for a likely mean reversion in the pace of global growth in 3Q14.
Yesterday night Singapore released its advance estimate for 2Q14 real GDP. That data showed the ever-volatile Singaporean economy more than cut in half from a rate of change perspective:
Two things stand out most to us:
While both inputs can be readily dismissed by a Consensus Macro growth bull (#1 because Singaporean growth is volatile and therefore difficult to forecast and #2 because of the small size of the Singaporean economy ($296B), a handful of large multinational corporations can have an outsized impact on Singaporean production), we would be remiss to do anything but interpret them at face value.
Why? Because Singapore is the arguably world’s most open economy from an international trade perspective. Specifically:
It’s should then come as no surprise that the slope of Singaporean growth tracks the slope of global growth quite well (i.e. these two time series exhibit a high degree of cointegration). At worst, Singapore’s high-frequency growth data should be viewed as a real-time read on the marginal state of the global economy.
As such, with Singaporean economic growth moderating so sharply in 2Q14, it’s reasonable to assume that global growth indicators will start to mean revert lower from what are incredibly stretched levels on a historical basis.
Quickly delving back into Singapore, we see that the forward-looking components to the SIPMM PMI survey are all decelerating on a trend basis, while inventories, imports and supplier delivery times (i.e. anything that might indicate the need to accelerate or decelerate production) is accelerating on a trend basis. In the context of crashing export growth, these signals do not bode well for the Singaporean economy’s ability to ‘comp’ difficult compares in 2H14.
If we knew nothing else about Singapore, we’d short it on those factors alone. Layer on an outlook for continued tight monetary policy (i.e. export growth-eroding SGD strength) amid a dramatic acceleration in inflation and a now-contracting, formerly-bubbly property market, and we are left with a tasty cocktail on the short side of Asian equities for 2H14.
Global growth bears: prepare to drop the anchor!
Associate: Macro Team
Takeaway: We reiterate our call of not having a high-conviction call on Japan here amid a convoluted globally-interconnected monetary policy outlook.
When we last published our extended thoughts on Japan, we openly debated the outlook for the “Abenomics Trade” (i.e. SHORT Japanese yen + LONG Japanese equities) with respect to the intermediate term. To recap the pros and cons of allocating capital to this investment strategy:
For those of you who like to get into the weeds on the numbers, please refer to our JUN 30 note titled “JAPAN POLICY VACUUM PART II?” for a deeper discussion of those puts and takes. It might not even be worth your time, however, as not much has changed since then.
Specifically, the BoJ’s latest policy meeting (statement out earlier today) was yet another nonevent. It left its QQE program unchanged, in line with the entire analyst community and the wording of the statement was broadly in line with previous guidance. Moreover, BoJ Governor Haruhiko Kuroda reiterated the board’s sanguine view of the Japanese economy and its progress on achieving #StructuralInflation in Japan.
In fact, a marginal tinkering of the FY14 real GDP growth estimate was the only update to their official guidance:
The key takeaway for investors here is that the resiliency of the Japanese economy post the APR consumption tax hike coupled with no material change in the BoJ’s own outlook for inflation roughly equates to an incremental delay in the timing of incremental easing (i.e. expanding their QQE program).
Speaking to that resiliency, the preponderance of Japanese high-frequency growth data is now accelerating on a trend basis as of JUN:
This sequential momentum is highly likely to support a bounce in real GDP off an easier compare here in 3Q14. To the extent that catalyst materializes, we could now be looking at the DEC 18-19 meeting or early-2015 for the timing of the BoJ’s next move, which would likely follow two consecutive quarters of decelerating CPI readings, or at least be in response to a dovish policy delta out of the Federal Reserve that impacts the currency markets.
A lot could happen between now and then, so, net-net, we do not think it’s appropriate for investors to gross up their exposures to the Abenomics Trade in either direction at the current juncture. While our late-MAY call for investors to cover Abenomics shorts was highly appropriate (e.g. the Nikkei 225 Index is up +4.9% since then), the outlook from here remains unclear.
As such, we reiterate our call of not having a high-conviction call on Japan right now. Up until very recently, we’ve had one since 4Q12 (in both directions of the Abenomics Trade), so we’re more than content to stand pat and let the data instruct our next move. Why force it?
Have a great night,
Associate: Macro Team
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