From January through the end of April this year, US stock markets had a clear and robust direction: UP. The rapid 20% market correction that we saw in late 2018 gave way to optimism that the economic environment wasn’t as bad as previously feared. The S&P 500 rallied +18% through the first four months of the year. 📈
But since then, the market has essentially gone nowhere. It’s chopped around, with a particularly choppy August. The old cliche saying “sell in May and go away” would have definitely served passive investors well:
The whipsaws from day to day haven’t gone unnoticed by others:
Now some of this volatility can certainly be pinned on Trump’s seemingly hot-and-cold approach to trade talks with China. But there are other, deeper forces at work.
It’s no secret that we are ~10 years into the current bull market, bond yields have been collapsing, yield curves are inverting, corporate profit growth is generally weak, and global macroeconomic data has been increasingly weak. Just this past Monday, the US manufacturing PMI (a widely followed gauge of manufacturing sector health produced by the Institute for Supply Management) signaled contraction for the first time in over three years. The Atlanta Fed reduced its estimate for Q3 GDP in the US as well. Major countries like Germany and the UK are already seeing declines in GDP. So it makes sense that some investors are getting worried and even getting out of the market. It also makes sense that other investors are hanging on to hopes of trade war breakthroughs, lower interest rates, and fiscal spending that could support markets in a critical upcoming election year. With these two opposing forces it doesn’t surprise me that the market has struggled to find a clear direction.
Where It Gets Weird
Now it gets more perplexing when I look at the divergences between various stocks and sectors underlying the stock market. There are entire sectors which appear to be pricing in recession with high probability: autos, retail, energy, steel, chemicals, materials, financials, casinos, and foreign stocks just to name a handful. Additionally, most companies with high net debt on their balance sheet have gotten whacked in the past couple of months. So what’s keeping this market afloat near all time highs?
Investors as a whole are still enamored with high growth stocks, many of which are unprofitable, particularly in tech & software. Valuations in software stocks still hover near decade highs, with many trading at double digit multiples of sales. Stocks like $SNAP, $VEEV, $OKTA, $SMAR, $MDB, $PLAN, $NOW, $TWLO, $TEAM, $ZEN, $ESTC, $DOCU, $PD, and many others. I won’t even discuss $BYND which is outright silly and not a high margin tech business at all.
There hasn’t really been a risk-off mentality with regard to these particular stocks, and it’s as if investors in these companies believe the good times will keep rolling. Now I get that these businesses are very good ones generally, with years of potential revenue growth ahead. But the aggressive expansion of valuation multiples this year means that the margin for error is TINY. And IF a recession hits, the unprofitable ones will find themselves in a hole where growth slows or turns negative, costs will need to be adjusted downward rapidly, and new funding might be needed just to escape bankruptcy. When the tech bubble burst quickly in 2000, many high flying tech stocks did not survive the next two years. Most lost more than 90% of their value. THAT is the risk that isn’t being priced into these high-flyer stocks today.
So it’s an oddly bifurcated stock market where the probabilities of recession seem very high on one side and very low on the other. Growth stocks have significantly outperformed value for the past few years. Investors have flocked to tech & momentum stocks which SEEM to have low volatility and steady gains.
The Contrarian View
My current view is, as it often is, somewhat contrarian.
While I don’t usually like to go sifting for stock ideas among cyclical sectors, capital intensive businesses, and businesses with high operating or financial leverage, these are places where I suspect high returns might be found in the years ahead.
Of course, I’m not going to buy stocks that have a high probability of getting wiped out in a mild or medium sized recession. I’m certainly going to prioritize companies that have good management teams, good capital allocation, profitability, competitive strengths, and low net debt. Surprisingly, companies like this do exist, even in hated sectors that are susceptible to downturns. And they often get sold off to silly valuation levels when their entire sector gets hit with waves of selling pressure.
Being a contrarian is hard and it takes guts. You question yourself every day. And if you are wrong, you might pass up gains elsewhere and/or end up with steep losses. But the rewards to being a contrarian and being right are ENORMOUS.
Hardly anyone wanted to buy $ROKU during the heart of a deep market correction in late December 2018. I did, because I could see the pessimism had extended much too far. The stock seemed like a good long term bargain around $27/share ($2.1B market cap at that time, <3.5X revenue and growing 40%+ annually with a huge growing addressable market). Just nine months later, every momentum trader wants a piece of $ROKU at a price that is over 6X (600%) higher than where I bought it less than a year ago. Funny how that works.
[Note 1: rarely does it work out that well that quickly! Note 2: I sold my position on the way up, much too early to capture all the gains, but that’s a story for another time 🤣 ]
That brings me to the retail sector, which is one of the aforementioned hated sectors. This sector has the unfortunate distinction of being vulnerable to a recession AND being subject to changing consumer behaviors that threaten the long term viability of many businesses within the sector (Amazon + the Internet threats). Naturally, I believe it might be fertile hunting ground for finding some very undervalued stocks.
This sector is bruised & battered. Out of 41 retail stocks that I’ve started tracking, only 5 have positive stock performance in the past year. The median return in the past year within this group of stocks is -40.6% and the median return year-to-date is -25.6%. Terrible!
Many of these retailers are being forced to close scores of their brick-and-mortar stores, and many are seeing declining year-over-year comparable store sales. Some even have a lot of debt on their balance sheet, in addition to being locked into long term store leases that hamper their ability to restructure / downsize.
However, 24 of the 41 companies are actually experiencing flat or positive comparable sales growth in the most recent quarter. 34 have repurchased shares in the open market in the past year, 17 have net cash (cash > debt) on their balance sheet, 26 pay a dividend, and 15 have insider buying in the past year. Even more interesting, the median valuation multiples are significantly lower than the market average: the median EV/EBITDA multiple is 4.7X and the median forward Price-to-Earnings (P/E) ratio is 9.0X. For context, the average P/E multiple in the US stock market is around 16.5X right now.
Where I think it gets particularly interesting is with a few of these stocks like Abercrombie & Fitch ($ANF). What?! Abercrombie & Fitch was a hot brand in the early 2000’s but didn’t it become irrelevant after people got sick of their overpriced moose laden t-shirts, ripped denim, awful brand image, and heavily cologne infused stores? Not quite. You see, A&F has undergone a turnaround in the past few years. They’ve revamped their image & clothing lines, closed some under-performing stores, attempted to improve their culture, expanded further internationally, and beefed up their online presence & e-commerce. They also own Hollister, which has performed well (positive sales growth) in the past few years.
It’s not the greatest business out there, but it’s a business that can currently generate about $200 million of annual free cash flow for shareholders (closer to $150 million this year due to elevated e-comm investment). Comparable store sales were positive in Q1 and flat in Q2, which isn’t bad in this weakish economic environment. Meanwhile the market cap has shrunk to about $950 million, and they have $250 million of net cash on the balance sheet. So effectively today the business is selling for just 3.5X cash flow (4.75X if you don’t back out the net cash). That is an absurdly pessimistic valuation. Even if a recession hits and free cash flow gets cut in half, the stock would STILL trade for a single digit free cash flow multiple. That feels like a decent value assuming you don’t believe ANF is about to head into rapid terminal decline, which I don’t see signs of at this moment in time. Management agrees and the company repurchased 3.5 million shares this past quarter, about 5% of the total outstanding in just one quarter. I love to see opportunistic stock buybacks that take advantage of low valuations, Outsiders style! Did I mention investors get a 5%+ dividend yield at today’s prices while they wait for a stock recovery? Not too shabby.
Now you might be asking, what about the better performing companies in this sector? Why go dumpster diving for value when you can buy faster growth, albeit at higher valuation multiples? Well there’s plenty of ways to make money in the market, so if that’s your approach I won’t knock it! But here’s a cautionary tale from just this week: $ULTA. Ulta Beauty is a fast growing cosmetics & fragrance retailer whose stock doubled in the past five years. Ulta has been putting up impressive comparable stores growth numbers for the past several years. But investors had bid up Ulta’s stock way above average retail sector & market wide valuation levels, assuming the company would keep delivering growth above their rising expectations. When Ulta announced a slightly disappointing, but still nicely positive Q2 earnings report (sales growth of 12% & comparable sales growth of 6.2%) the stock lost 30% in one day! It just shows the risk inherent in buying high valuation stocks that carry very high expectations.
At some point $ULTA could be a compelling stock idea itself…
Wrapping Up (For Now)
Now there’s a few other stocks in the battered retail sector that look interesting to me right now. There’s also a retail REIT that I find quite intriguing (not in the list above). And that’s just in retail, I haven’t even gotten to the other beaten up sectors! But this post is already quite long so I’ll save all of those for another day 😎