Some Random Thoughts
(April 17, 2008)
Dear Subscribers and Readers,
Our regular guest commentator, Rick Konrad of “Value Discipline,” has been traveling and hasn't had the chance to put together a guest commentary for us. He will be back next week at this time, in full swing. In the meantime, I want to offer our readers a couple of “random market thoughts” that I consider to be worth tracking over the next 6 to 18 months. So without further ado:
The Great Deleveraging
The Great Deleveraging continues – as troubled bedding and furniture retailer Linens ‘n Things is expected to file for bankruptcy in the next few days on the heels of a crushing debt load and declining same-store sales. Assuming most of their stores are shuttered over the next six months (which is the most likely scenario given the difficult financing environment), this should act as a good tailwind for existing bedding and furniture retailers, such as Bed Bath & Beyond (suddenly, analysts are no longer criticizing BBBY for the “conservative” management of their balance sheets; disclosure: I am long BBBY in my personal portfolio). Even retail chains that have managed to avoid bankruptcy (so far) are making a concerted to conserve cash, such as Foot Locker (closing 140 stores in the next 12 months), Ann Taylor (closing 117 stores), and Zales (closing 100 stores, and probably helping out Blue Nile in the process).
Access to cheap financing has been the mean reason why the competition has been fierce in the retail industry and the consumer discretionary sector over the last few years. Companies that did not have the ability to compete in the long-run, i.e. companies that had no right to exist, were able to continue to survive as lending became freely available as long as loans can be securitized and sold with a decent rating. Not only did this once-in-a-generation phenomenon drive sales away from better-run retailers, it also compressed margins across the retail industry – as rents and wages were bid up across the industry and as “good locations” became increasingly scarce. This – along with the fact that U.S. consumers never really retrenched during the last recession in 2001 – was the major reason why we never witnessed the sort of performance from retailers that we saw during the last recession in the early 1990s, when the S&P retail index returned 125% over a two-year period beginning October 1990, versus a two-year return of only 75% beginning at the trough in October 2002.
As the U.S. economy and financial sector continue to deleverage over the next 12 to 18 months, I also expect growth stocks to outperform value stocks – as many of the latter issues will become “value traps” instead of stock market bargains. Investing in turnarounds over the next 12 to 18 months would be a futile exercise for most investors. We witnessed a similar phenomenon in the U.S. stock market coming out of the leveraging and LBO phase in the late 1980s (when Michael Milken was “king” of the junk bond world). The following table charts the outperformance of growth stocks versus value stocks across the entire market cap spectrum during the calendar years 1989 to 1991 (highlighted in yellow):
Note that the action in 2007 has been very similar to that of 1989 to 1990. In addition to an outperformance in growth stocks versus value stocks, we also saw an outperformance of large cap stocks versus small caps stocks, as the former are perceived to better able to weather a credit crunch than their smaller counter-parts. While 2008 hasn't been kind to growth stocks thus far (primarily because of the underperformance in Google, Apple, and technology stocks in general during the first quarter), I expect them to come back with a vengeance for the rest of 2008.
Don't get me wrong, I like value stocks. I just do not like them in a general credit crunch and deleveraging environment. Subscribers should keep in mind that many stocks that are trading at low P/Es and low P/Bs tend to be:
- Highly cyclical in nature – such as stocks in the materials sector or engaged in manufacturing (i.e. firms with high fixed costs or selling a commoditized product/service).
- Struggling in a turnaround situation. Note: Stocks usually trade at low valuations for a good reason, given today's light-speed access to information. In a credit crunch environment, many companies that could've turned around will not be able to – simply because of the lack of access to cheap financing (if they could get it at all), or a weak economic environment.
That is why – over the next 12 to 18 months – it is far more preferable for investors to focus on companies with strong and consistently growing cash flows (these stocks tend to trade at higher valuations than the market's), as opposed to speculating on value stocks or “turnaround” situations. Once the “great deleveraging” hits the 8th or 9th inning (to borrow a term from baseball), it would be time to start buying value stocks or to speculate on turnaround situations once again. For those investors who do not care to buy into growth stocks with high P/Es or high P/Bs, it may be better to sit out in cash over the next 12 to 18 months before buying – as buying value stocks coming out of a system-wide deleveraging phase – tends to be one of the most profitable opportunities in a lifetime.
By extension, I believe this is one reason why the traditional “quant funds” (those that tend to focus on “value factors” as inputs to their models) would continue to struggle over the next 12 to 18 months. Not only are many of these quant funds using the same models, data, and risk management systems, but most likely, their input factors will fail them as the U.S. economy continues to deleverage going forward, hitting many of their stocks in the process. In such an environment, the funds that tend to outperform are the funds that actually engage in fundamental research (subscribers may be surprised to know that there are 130/30 funds out there whose investment process is based on fundamental research). This is an issue that I will revisit every now and then – for now, I remain very wary of quant funds in general and their ability to produce “alpha” over the next 12 to 18 months.
According to the Commerce Department, housing starts plunged to a seasonally-adjusted annualized rate of 947,000 during March, the lowest in 17 years. This is also the first time that housing starts has declined below the one million mark since 1991, as shown in the following chart courtesy of Morningstar.com:
Interestingly, over the last 50 years, housing starts (seasonally-adjusted annualized) have only been below the one million mark for only 22 months (23 months if one includes March 2008). While I am not predicting a bottom in U.S. housing prices anytime soon, there is a couple of interesting trends:
- Demographics: The "Y-gens" are now just coming out of age and are starting to form households and buy starter homes. Most estimates put this at an additional 150,000 households on an annual basis over the next decade at the very least, if not over the next 15 years. For comparison purposes - during the last housing bust in the early 1990s - household formation fell off the cliff as the baby boomers literally stopped buying in 1989. As shown in the above chart, housing starts were only below the one million mark for five consecutive months in the last housing bust in the early 1990s. While the housing boom in recent years was arguably more speculative, subscribers should note that demographics is much more favorable this time around – with a potential swing of 300,000 households every year to the buying side relative to the early 1990s.
- The subprime resets that were due to hit this year are now essentially a moot point, given that the majority of resets are tied to LIBOR. Assuming the Fed cuts by another 25 bps on April 30th, and assuming LIBOR follows, we should see adjustable-rate subprime mortgages resetting to generally lower rates in the latter half of this year. In terms of resets, the “black swan” to watch out is no longer subprime resets, but Option ARMS (negative amortization loans) resets. However, option ARMS resets are not projected to hit the market in a substantial way until the June to July 2009 period. Given that 14 months is an eternity in this market (i.e. this is a well-published trend and anything could happen between now and then), I would not worry about this for now, especially if housing starts continue to decline for the next several months (thus restoring some kind of order and “equilibrium” to the housing market across the country). On the positive side, the option ARMS resets and the ensuing foreclosures may give us that final “cleansing out” that we are looking for as a signal to the end of this “great deleveraging.”
Henry To, CFA