Scott Fearon

Scott Fearon has spent more than 30 years in the investment business. He is the author of Dead Companies Walking: How A Hedge Fund Manager Finds Opportunity In Unexpected Places.

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Grand Canyon Education Is Still a Growth Stock

Grand Canyon Education (LOPE) has been a core holding of my $100M fund for the last five years. Grand Canyon operates a beautiful 300-acre college campus ten miles north of downtown Phoenix. The school will enroll 17,000 ‘ground students’ next fall. It also has over 60,000 online students, most of whom are adult learners (over 21-years-old) seeking to restart their undergraduate studies or pursuing certificates and master’s degrees in their chosen professions.

I first wrote about Grand Canyon nearly three years ago, just before I gave a presentation on it at the 2014 Ira Sohn Conference in San Francisco. LOPE was trading for around $43 a share at the time. I continued to write about Grand Canyon over the next two years, praising its impressive growth, smart management, and the quality education it provided. And yet, despite doubling its EPS and beating analysts’ estimates over a dozen quarters in a row, the stock barely budged. At the time of my last piece on the company, in April of 2016, LOPE was trading for … around $43 a share.

The main reason for LOPE’s persistently flat performance was that it was a very good stock in a very lousy neighborhood. The negative sentiment around the for-profit education industry—which is well-deserved for nearly every company in it, with the exception of Grand Canyon—kept investors from buying into what was one of the most impressive businesses I have ever come across in my three decades of money management.

It took until last fall for the markets to finally recognize Grand Canyon’s excellence. LOPE hit $80 last week, up roughly 100 percent over the last year and nearly 300 percent since my fund first entered the position. Nonetheless, I believe Grand Canyon remains one the best growth companies in America today.    

One of Grand Canyon’s greatest advantages is that it competes with poorly run public and private universities. Grand Canyon makes a 31 percent operating profit margin while charging its ground students ‘only’ $17,000 for a full year of tuition, room and board. Most private schools charge at least three times that much, yet very few can even break even at those rates. Secondly, because LOPE has a Christian identification, its students are much more motivated to learn and less likely to engage in destructive personal behavior—and once they graduate, they pay back their student loans at a higher rate than alums at most public and private schools and nearly all for-profit universities (with the possible exception of Liberty University in Virginia).

Lastly, LOPE is striving to improve its academic reputation in order to compete with the best private and public US colleges. Incoming LOPE ground students have an average high school GPA of 3.5. Many are national merit scholars. And roughly half of them major in STEM subjects (science, technology, engineering and math), a much higher percentage than students at most public and private schools in America. Each year, more LOPE alums enter prestigious Ivy League graduate programs, as well.

In 2017, Grand Canyon should produce yet another year of double digit growth. Revenues will be almost $1 billion, and LOPE’s exceptional senior management believes EBITDA will exceed $300M for the first time. Because capital expenditures will be roughly $80M this year (down from almost $200M in 2016) LOPE’s cash will build. The most likely use for the capital will be a sizeable buyback authorization. While management is hesitant to invest in a ‘greenfield’ new campus, that could also be a possibility, though probably not this year.

Despite its incredible performance, a mere five analysts cover Grand Canyon, and most Wall Street research on the company fails to highlight its Christian orientation. That is a major omission. Lumping LOPE in with other for-profit schools like DeVry that have flat to shrinking revenues and are focused on a much less motivated student population is the reason so many folks missed out on this stock in the first place.

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Snap’s Fizzle Is Business as Usual for IPOs

SNAP gagged sooner than most IPOs, but it is following a familiar pattern.

Snap, Inc. didn’t wait long to let down its eager investors. Year-over-year, revenues in its first quarter as a public concern were up almost 300 percent, but that badly lagged expectations and even fell short of last quarter’s number. User growth was tepid, as well. The former unicorn gained a mere 8 million new customers over last quarter. The markets don’t tend to like growth stocks that stop growing and Snap’s stock predictably reeled on the news, dropping almost $5 to $18.05, well below its $27 March all-time-high and barely above its $17 IPO price earlier that month. Oh yeah, Snap also lost $2.2 billion dollars, most of it in a one-time non-cash charge for stock-based compensation. At least some people are getting rich off the company. Its shareholders? Not so much.

First and foremost, Snap’s drop is a cautionary tale for anyone tempted to buy into an IPO. Numerous academic studies have shown what a bad idea this is. As a group, newly minted stocks underperform the market over any meaningful time period. The great performance by Snap’s primary competitor Facebook is the exception, not the rule. Most IPOs gap up on the first day of trading, but soon fall off. Many become single digit midgets in a few short years. I’ve been around long enough to see this play out repeatedly across multiple industries. Believe it or not, for a time in the 1980s, the hottest IPOs in the market were in the asbestos abatement business. Like Snap, these companies were afforded grotesque valuations on astronomical growth projections. Like Snap, they all soared on their debuts and gagged shortly thereafter. Many went all the way to zero. A few years later, the IPO craze du jour was CD-Rom education companies. They, too, failed to justify their rich valuations.

Personally, I cannot understand why anyone would use Snap’s goofy service, let alone buy its stock. Most Snap users are kids in their teens and early 20s. Those aren’t groups known for meaningful disposable income. Yes, they are hard to reach. Yes, like Facebook, Snap has a laser ability to target ads to them. But if Facebook is a mind numbing ‘electronic scrapbooking’ site, Snap is an odd mixture of Tiger Beat and Playboy/Playgirl for frisky teens. Which is to say, it is a colossal time waste of time. Most importantly, from an investing standpoint, any teen apparel retailer can tell you how brutally difficult it is to cater to fickle teenagers. They change their tastes and their buying habits like they change their clothes. Maybe the only sites on the internet more at risk of falling out of favor than youth-oriented social media platforms are dating sites. If (or, rather, when) Snap loses its appeal, its user count could collapse—and quickly. That might already be happening. Facebook’s Instagram launched a virtual copycat version of Snap’s platform a few months ago and it has already surpassed Snap’s user count. Meanwhile, Facebook’s main site has become the go-to social media platform for middle aged and older folks. Those consumers don’t tend to switch to the hot new fad when it comes along. Most of them will probably keep on using Facebook until they die.

If Snap’s user count continues to disappoint in subsequent quarters, its stock will be valued on a multiple of EBITDA, not revenues. Given that Snap is hemorrhaging cash, that would push it into negative territory. Not good. I am not short Snap’s stock, and probably will never be, but it could easily make Twitter look like a good investment. The same goes for its former unicorn brethren, like the ride sharing giants Uber and Lyft. Uber, like Snap, is incinerating cash. Unlike Snap, Uber is a commodity service. Yes, most of its users prefer ride sharing to cabs. I know I do. But I and everyone else who uses the service will gladly jump to a competitor if they offer a better deal. That means Uber’s breathtaking topline growth will likely never translate into meaningful profits margins, which means its all-time high valuation as a private or public concern is probably right now. At some point, after the hope and hype for the future fade, all public companies trade on a multiple of earnings. If Uber ever gets public—and that might be the only way its current investors make a decent return—the same rules will apply. Contrary to popular belief, things are never “different this time.”

An interesting side question is whether the ride sharing industry continues to decimate the rental car business. Hertz and Avis both turned in terrible first quarter results. Both are selling at 52-week lows and both have big debt loads. As ride sharing becomes more common, especially at US airports (where car rental firms generate their highest profits), these companies may be forced to reorganize (ie, file bankruptcy) as they downsize and figure out new ways to compete.

(top photo credit)

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A Short Guide to Short Selling

Short selling sounds sexy. Uncovering accounting fraud or identifying companies promoting faddish products or services can be exciting. But short selling is often an unprofitable and frustrating activity, best left to institutional investors. Most ‘professional’ short sellers have produced awful results. The $110M AUM Federated Prudent Bear fund is down 75 percent over the last 18 years. The $186M AUM Grizzly short fund is down 90 percent since 2000. And famous New York short seller Jim Chanos’ Kynikos short fund has reportedly turned $1 into a dime since its inception.  

The population of dedicated short sellers has steadily declined during my three decades in money management. Most, if not all, delivered disappointing performance, lost assets, and closed shop. Some claim that, despite losing money, they generated ‘alpha’ because their funds declined less than the indexes advanced. This is like bragging about finishing second-to-last in a game of Russian roulette where there are five bullets in a six shooter. You may have lasted longer than the average participant, but you are still dead.  

Today, many managers are shorting index funds and ETFs to claim their funds are market neutral. Why do they do this? To justify charging a performance fee without doing the intensive research required to identify and profit from winning short investments. Because the best short ideas almost always have market capitalizations below $200M—and have minimal trading liquidity—asset managers with excessive AUM cannot make meaningful short bets in troubled, often low priced stocks where the risk-reward ratio is on the side of short sellers.

Given the difficulty and risks, individual investors are advised to avoid shorting. But identifying stocks that are likely to decline—possibly to zero—can provide insights into stocks all investors should avoid owning. Simply put, the best stocks to short are the worst stocks to buy. This might seem like a blatantly obvious statement, but folks consistently buy stocks they would be better off shorting and short stocks they’d be better off buying. Here are a few reasons why this happens:

1) A fixation on being “early”

As I have repeatedly warned, buying low-priced (sub-$5 stocks) and/or the stocks of money losing companies are terrible ideas. If a stock is trading in the single digits, that is almost always a clear indication that something is seriously wrong. The vast majority of these low-priced losers never recover—and the small fraction of troubled companies that do manage to turn themselves around are almost always better buys once their stocks cross back into double digits. That momentum shows that the market has begun to taken notice of the recovery, which almost always leads to greater momentum to the upside.

Conversely, formerly high-flying stocks that begin to decline are almost always better shorts once they lose half their peak value or more (preferably a lot more). Shorting a stock before it hits this point on the downside is extremely dangerous, especially when the company in question is still profitable.

One of the few short positions I’ve written about publicly offers a perfect example of the dangers of shorting a company too early. A few years ago, Intuitive Surgical posted a few bad quarters and its stock dropped from the high-$500s into the low-$400 range. As I made clear at the time, I knew Intuitive was (and still is) a great company with smart management, but I believed declining prostate surgery procedures and slowing sales of its robotic surgery device would bring its still high price-to-earnings multiple down closer to the S&P 500 average. So much for that idea. As anyone who has followed Intuitive can tell you, growth picked up again and the stock followed suit. This week it crossed $800 for the first time. Luckily, I recognized my error and covered my position long ago.

2) Overvaluing valuation

Value traps are dangerously seductive. Investors get so caught up in book values, low multiples of earnings or cash flows and other seemingly attractive metrics, they forget that the lifeblood of any successful business is growing revenues. Investing in a company with shrinking revenues is always a risky proposition, no matter how “cheap” its other numbers appear. On the other hand, shorting companies with rapidly growing top lines is a good recipe for going broke. 

For decades, many short sellers have attempted to “pick a top” in richly valued stocks. This rarely happens. What do Tesla and Netflix have in common? Rich valuations and bottle rocket revenue growth. Yes, their stocks are indisputably expensive, almost ludicrously so. Yes, they may eventually collapse. But as long as they keep growing revenues rapidly, they could both easily double again without ever generating profits or free cash flow. Remember John Maynard Keynes’s legendary quote: “The market can stay irrational longer than you can stay solvent.” Market history is full of overvalued companies that remained stubbornly overvalued long after most shorts busted out or cried uncle and covered.

Shorting a stock on valuation alone is an especially bad idea when it comes to established, profitable companies. When I originally wrote about Intuitive Surgical, its stock was selling below 30x earnings. It currently sells at 43x earnings. Shorting it at less than 30x proved to be a bad idea a few years ago. Shorting it at 43x would almost certainly be an even worse idea now.

3) Undervaluing the perils of debt

The best shorts (and worst longs) are usually companies with shrinking (or no) revenues, relatively large negative cash flow from operations, and often excessive debt. As I’ve written before, if a company has public debt, and that debt has a yield to maturity of 15 percent or more, fixed income investors are already pricing in a high likelihood of bankruptcy. And yet, time and time again, I’ve watched the stocks of companies with high-yielding debt remain elevated for long periods of time, sometimes right up until they officially chapter out.

Many equity investors simply don’t understand the capital structures of publicly traded companies, or how bankruptcy works. Others are so emotionally attached to a company’s story or business model, they want to believe that their low-priced investment will pay off big for them. Whatever the motivation, buying low-priced, heavily indebted companies turns stock investing into the equivalent of buying lottery tickets, with equally long odds.

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Three ‘Uninvestable’ Industries for 2017

The “Trump Bump” will soon come to an end, and earnings will once again drive stocks higher or lower. Bulls think 2017 S&P operating earnings could hit $130 per share. Who knows if this happens? Even in times of relative stability, it’s foolish to predict the markets—and probably the only thing everyone can agree on these days is that our current situation is far from stable. There are too many variables, including uncertainties about the policies President-elect Trump will put forward, to have any clue where the market will wind up at year’s end. Will Trump succeed in cutting the corporate tax rate or start a crippling trade war with China? Will he “repeal and replace” the Affordable Care Act or throw the whole healthcare sector into chaos? Your guess is as good as mine, and anybody who claims to know is probably a partisan hack or a salesperson, or both.

One thing we can be sure of is that, as always, a handful of big movers will disproportionately impact the indexes in 2017. Last year Nvidia was that stock. I wish I knew what this year’s breakout name will be, but all I can offer with some certainty is that even if the indexes post another year of low double-digit increases, more stocks will struggle than flourish. Quite a few businesses could vanish altogether. Avoiding these laggards and soon-to-be zeroes is just as important to investing success as scouting for potential five or ten baggers. And one of the best ways to do so is to identify larger secular trends.

Austrian economist Joseph Schumpeter famously applauded the “creative destruction” aspect of capitalism, the method by which companies, and entire industries, go broke because a person or a company invents a better way of doing things. Analyzing this process is not easy. Nobody rings a bell alerting investors to sell stocks about to be disrupted into oblivion. If anything, as I’ve described before, they often appear temptingly inexpensive by valuation metrics such as price to earnings or price to cash flow just before they vanish. Moreover, analysts and pundits often encourage bottom fishing for seemingly cheap stocks in troubled industries. I still have a stack of bullish analyst reports recommending stocks in forgotten sectors like video rental stores, pay phones, and pagers. All of them cited attractive valuations. Most of the companies being recommended no longer exist.

Even businesses that manage to survive industry bloodbaths rarely, if ever, receive premium valuations again. Technology stocks are great examples. Disk drive survivors Seagate and Western Digital perpetually sell at low PE ratios, as do auto-industry survivors General Motors and Ford. If GoPro and Fitbit recover from last year’s drubbings, both are likely doomed to sell at a fraction of their once rich valuations.

Today, three industries (and others I have yet to identify) are facing severe disruptions. First, and foremost, is brick-and-mortar retailing. Hardly a week goes by without a high profile retailer reporting disappointing monthly or quarterly sales, followed by a stock price collapse. Macy’s and Kohl’s both rang in the New Year by dropping 14 percent and 19 percent, respectively, on weak Christmas sales. Meanwhile, e-commerce competitors, especially Amazon, are rapidly taking market share. Amazon’s 2016 revenues were over $135 billion, vs. $107 billion in 2015 and $89 billion in 2014. By comparison, Walmart’s 2016 revenues were about $486 billion, vs. $482 billion in 2015. In other words, the most powerful force in brick-and-mortar retailing over the last generation has virtually stopped growing while its main online competitor has been growing steadily at 20+ percent and shows no signs of letting up.

Many smaller retailers recently filed bankruptcy, including Pacific Sunwear, American Apparel, Wet Seal, Aeropostale, Sports Authority, Sports Chalet, and Fairway Grocery Stores. Existing public chains facing extinction include Sears, Gordmans, Bon Ton Stores, HHGregg, and Stage Stores. There will be more, and the survivors will sell at ever-lower valuations. This powerful trend prompted Wells Fargo to label the entire group as close to “uninvestable” following poor holiday sales and the just completed annual ICR retail conference in Orlando.  

The asset management industry is also facing headwinds. A secular shift toward indexing, plus the soon the be implemented Department of Labor “fiduciary rule” has led to declining assets and declining fees at most mutual fund companies. Assuming this trend continues, these firms will reduce or eliminate their stock buyback programs while others will cut or eliminate quarterly dividends. Historically, these companies have been highly profitable. Gamco paid its leader, Mario Gabelli, roughly $1 billion in cash over the last ten years. Most have minimal debt. But as revenues and profits shrink, price earnings ratios will also likely fall. The upshot is potential declines of 20-50 percent for many industry stocks. Unless these companies are bought out, most could (or should) underperform the market in the next 12-24 months.

A third troubled industry is offshore energy supply companies. As more and more cheaper and easier to extract oil is discovered onshore, energy companies will likely reduce exorbitant offshore exploration efforts. This will reduce revenues at firms like Tidewater, Hornbeck Offshore, Bristow and Ion Geophysical. All four depend on offshore drilling and exploration, and all have debt. If oil prices are flattish in 2017, all four will report losses and see further share price declines. Ten months ago, I identified eight exploration companies with high yielding debt—Basic, Stone, Ultra, W&T Offshore, Exco, Gastar, Energy 21, and Linn Energy. Six have since filed Chapter 11. While bankruptcy is not as imminent for these four offshore service companies, all face a difficult future.  

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Will the Trump Rally Cost Us in the Long Run?

Stocks have soared ever since Donald Trump stunned everyone by winning the presidency, but Trump’s victory was far from a landslide mandate. Hillary Clinton won the popular vote by over 2.6M votes. This marks the fifth time a president has won the electoral college but lost the popular vote—and Trump’s popular vote deficit was much larger than the previous four times this election outcome occurred.

But before Democrats claim a moral victory, they would be wise to examine the congressional tally. According to the Wall Street Journal, Republicans won 3M more House votes than Democrats. That means a staggering 5.5M voters picked Clinton and then voted for a Republican congressional candidate—which not only speaks volumes to Trump’s personal unpopularity, but to the rightward drift of white voters.  

The ongoing Trump Rally shows that markets approve of PEOTUS’s vow to lower corporate taxes, simplify personal taxes (Trump wants to reduce today’s seven rates to three), and reduce regulations. Energy and financial stocks have gained the most, while tech stocks have lagged. Last year’s big winners, the so-called FANG stocks (Facebook, Amazon, Netflix and Google) have not participated in this celebratory advance.

I anticipate that this trend will continue. Trump lost tech-rich California by 4M votes. Not surprisingly, his ‘kitchen cabinet’ features no Silicon Valley luminaries. From a regulatory standpoint, tech has the most to fear from the new administration. Early in his candidacy, Trump lamented the destruction to local merchants from Amazon (and Trump is also no fan of the Jeff Bezos-owned Washington Post.) Despite the new president’s penchant for late-night tweeting, investors should be wary of owning social media stocks, given their rich valuations and the potential adversarial relationship with Washington.

Wall Street and financial industry stocks have fared better since election day and should continue to do so. Trump wants to end the Fed’s zero interest rate policy and has pledged to purge the Fed of doves like Chairwoman Janet Yellin, whose term expires in early 2018. Higher rates will increase bank profits by increasing the net interest margin from lending. If Dodd-Frank is gutted, smaller banks should grow faster, as well.  

But investors need to be careful what they wish for. Less than a decade ago, we got a crash course in the consequences of an unregulated Wall Street. The Consumer Financial Protection Bureau has reduced predatory behavior like payday loans, exorbitant credit card fees, and destructive mortgage terms like negative amortization (thank you Golden West and the Sandlers for making these toxic loans commonplace). Moreover, the recent Department of Labor edict forcing advisors to be fiduciaries first and salespeople second should reduce the excessive fees embedded in mutual funds and other investments. Despite some hopes on Wall Street that the Trump Administration will block implementation of this law in 2017, I suspect it will be enacted as written, and the mutual fund world will either have to adapt or continue to lose assets. I would not own—and might short—the worst positioned players like Waddell & Reed and Franklin Funds.

Finally, while Trump’s proposals might stimulate growth, I am wary about his refusal to address America’s gigantic $19 trillion debt burden. This problem, as outlined in the book This Time is Different by respected economists Rogoff and Reinhart, could keep growth at the sluggish, sub-3 percent rate seen throughout President Obama’s eight years. If that occurs, the S&P may well disappoint the bulls and produce single-, not double-digit gains during Trump’s time in office.

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Taking Stock of Trump’s Triumph

Donald Trump’s stunning victory blindsided investors and media pundits alike—not to mention part-time finance bloggers like myself. Last week, I all but guaranteed a Clinton victory, and predicted that it would probably lead to slower earnings growth for health care and energy companies, as well as continued anemic economic growth for the country as a whole.

So much for all that.

The biggest loser of the election, besides Clinton, was the polling industry. Either pollsters are incompetent and/or they let their preference for Clinton (or more likely their hatred of Trump) influence their techniques and conclusions. The vote total was also surprising, with fewer votes overall going to Trump or Clinton compared to Obama/McCain in 2008 and Obama/Romney in 2012. Indeed, as other outlets have pointed out, Trump won with fewer votes than Romney’s losing vote total. He gained 42 percent of female voters, vs. 44 percent for Romney four years ago and won 29 percent of Hispanics, vs. 27 percent for Romney. So what happened? African-Americans stayed home in droves. It appears that Clinton attracted several million fewer votes from that reliable, 90+ percent Democratic constituency. Meanwhile, Trump pulled in a fair number of white, non-college educated Midwestern voters who had never voted Republican (or never voted, period). The combination of those two effects helped him sweep the once solidly blue Rust Belt states of Wisconsin, Michigan, Pennsylvania, and Ohio.

Stock investors were clearly just as befuddled by the result as everyone else. Dow futures were down nearly 800 points soon after Trump made his 3 AM EST acceptance speech, but that changed quickly. The Dow opened down only 15 points and rallied steadily, ending Wednesday up 257 points, or 1.4%, for a record closing high. As the day progressed, it seems stock buyers remembered Trump’s vow to lower both corporate and individual tax rates, and his proposal to create a ‘tax holiday’ so US companies could repatriate up to $3 billion in profits held offshore (without paying further taxes to the IRS). With Republicans in control of the Senate and House, these pro-growth proposals might actually happen, and happen quickly, so it’s little wonder the markets rebounded so convincingly.

Health care and financial stocks led the way higher. Health care stocks were the market’s worst performing sector in 2016, as investors feared intensified regulation under a Clinton White House and Democratic Senate. With Republicans controlling all three branches, I suspect health care stocks will continue outperforming through year end. Bank stocks also jumped, as Trump has criticized the Federal Reserve zero interest rate policy. Trump is highly likely to replace dovish Fed chair Janet Yellen, possibly before her term expires in 2018. In that scenario bank profits, and bank stocks, could be surprising winners. I own two Texas bank stocks—Texas Capital Bancshares (TCBI) and Legacy Texas (LTXB)—and would encourage investors to buy high quality regional banks like these into this potentially ongoing rally.  

Trump may not be all good for investors, however. He has shown no willingness to propose solutions for our looming entitlement shortfall, and many predict deficits during Trump’s presidency could be worse than the $500 billion to $1 trillion deficits during Obama’s eight-year reign. Someday, possibly while Trump is in office, investors might demand the US pay much higher interest rates on our already massive $19 trillion debt. Stock prices would almost certainly suffer in that event.

Personally, I wish Mr. Trump well. He was not my first (or second or third) choice. But I hope he can make our already great country even greater.  

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The One Election-Proof Industry

After one of the longest, weirdest, and most exhausting election seasons in our history, we are only six days away from (finally) choosing a new president. As importantly, 34 Senate seats and all 435 House seats are up for grabs.

Investors are justifiably nervous about the outcome. Yesterday’s selloff was probably a symptom of that unease. Betting markets currently predict Hillary Clinton has a 70-75 percent chance of winning. I suspect her odds are much better. Four years ago Obama’s five million vote victory was fueled by a 56 to 44 percent majority of female voters and an even greater 74 to 26 percent majority of Hispanic voters. I am 99 percent certain Trump will do worse with both groups. Ever since he announced his candidacy Republican leaders (and media talking heads) have known that women and Hispanics would be his Achilles heel and yet, shockingly, he has made no effort to improve his appeal to these voters. Either he is delusional about his chances or simply refuses to learn the daunting math required for a Republican to win the general election.

The Donald’s only hope is the fact middle-of-the-road voters seem to dislike Hillary almost as much as they dislike him.

In the short term, traders might buy today and sell soon after the election. Observers believe there will be a ‘relief rally’ following Clinton’s likely victory. Her win is somewhat, but not completely, priced in the market. But President Clinton II could be bad for profits of multiple industries. Foremost is healthcare. These stocks have underperformed in 2016, as investors fear Hillary will review and/or regulate price increases by healthcare and pharmaceutical firms. She might also limit the profit potential of the fossil fuel industry via regulation and environmental edicts. Lastly, Clinton will not reduce our 35 percent corporate tax rate or propose a territorial tax code that stops ‘truing up’ offshore profits when they are repatriated to the US. Add it all up and economic growth will probably continue at a subpar 2 percent (or worse) annual rate, which means it is highly unlikely the stock market will produce double-digit annual gains in any year of Clinton’s presidency.

As unappetizing as that sounds, Clinton is the devil investors know. Trump is the devil investors don’t know. If he beats the odds and wins and actually builds his promised 1800-mile wall on the Mexican border, legal and illegal immigration would likely slow to a trickle. That would kill our already disappointing level of startups, as first generation immigrants start roughly one third of all new companies. And if President Trump even so much as threatens tariffs on imported Chinese goods, we could see a full-blown tariff war and worldwide recession.

The lack of transparency by both candidates probably reveals how they would govern: opaquely and with minimal transparency. Unlike every presidential candidate in the last four decades, Trump refuses to release his tax returns. Amazingly many Americans seem not to care. I suspect those returns show nonpayment of taxes, minimal charitable contributions, and/or financial deals with unsavory Russian and/or Middle Eastern entities. Meanwhile, Clinton has hidden or destroyed thousands of emails written during her tenure as Secretary of State and also refused to produce a transcript of a speech she gave (for a six figure sum) to a Goldman Sachs event years ago.

The one industry that is likely to escape unscathed no matter who prevails is my own. Both candidates claim they will end the egregious ‘carried interest’ tax loophole. President Obama made the same pledge eight years ago. This loophole lets hedge funds, private equity funds, and many real estate partnerships pay long-term capital gains tax rates on their annual performance fees. Private equity and real estate firms are its biggest beneficiaries. Like Obama, Hillary is unlikely to pursue this change, as her connections to the avaricious, unprincipled New York investment community are well documented. At the same time, today’s politicized Federal Reserve is probably going to keep interest rates at or near zero for years. Why? Because every threatened rate hike causes a market selloff, followed by the Fed deferring rate hikes to future years. Washington clearly cares more about propping up stock prices than rewarding savers—and people wonder why populist anger has been driving the Trump (and Sanders) candidacies.

No matter what happens next Tuesday, I don’t see that anger abating anytime soon. Washington—and Wall Street—had better start paying attention to it or the next election could make this one seem tame by comparison.

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Headline Risk Is Still Poison For These Stocks

Stock picking is hard. Most institutional and retail stock pickers underperform the indexes. But every investor could improve the likelihood they beat the market by following one rule:

Avoid high profile, controversial companies where an adverse news event could produce an overnight price collapse.

Three stocks have proven the utility of this investing rule in spades: Valeant Pharma, Wells Fargo, and Mylan Labs. All three have been scrutinized for behavior labeled unethical by some and illegal by others, and all three have cost their investors in a big way because of it.

In February, I cautioned that an upcoming Congressional investigation into Valeant’s pricing policies might unveil further malfeasance by the company’s management. VRX was $92 then. It closed at $22 today. While the hearings produced no bombshells, a few weeks later management reported disappointing fourth quarter earnings and drastically lowered earnings guidance for 2017. The stock dropped 40% to $36 in a single day, and has slid lower since.  

Had folks followed my rule, they would have unloaded Valeant as soon as news surfaced that it had a lengthy history of buying prescription and OTC drugs (with money borrowed via multiple Wall Street bond offerings) and then drastically raising drug prices. The stock was still over $200 when these damning stories first emerged. But many investors—including a who’s-who of the hedge fund industry—held onto their Valeant stakes, betting that good times were sure to return as the negative press faded and headline risk abated. Even Wall Street ‘experts’ who openly acknowledged the company’s troubles refused to believe things could get significantly worse.

On September 28th, 2015, with Valeant’s stock still trading for $199/share, Nomura analyst Shibani Malhotra initiated coverage on the company. In a thorough 46-page report, Malhotra rightly called VRX a “controversial company that polarizes investors” and noted its “aggressive pace of M&A, which some perceive as an unsustainable ‘roll up’ strategy.” And yet, Malhotra still rated the company a buy, pegging its upside at $335/share and its downside at a mere $180—only $19 (or 10 percent) less than the stock was trading for on the day the report was issued.

Oops.  

One year later, the rot within Valeant is still being unearthed, and its stock keeps on falling. Just this week Wall Street analyst David Maris dug up another example of quasi-criminal behavior. Apparently Valeant induced doctors to prescribe its second biggest product, the antidepressant Wellbutrin XL, through the obscure mail order pharmacy ‘Direct Success.’ Even though much cheaper generic competitors to Wellbutrin existed, Valeant increased Wellbutrin’s list price 11 times over the last few years to $17,000 annually. Who knows when, or if, another negative story around Valeant is discovered. But with over $30 billion of debt and now shrinking revenues, it’s an extremely risky stock that could very well zero out. Now that is a downside risk.

The recent Wells and Mylan scandals could drag on just as long as the Valeant saga, and potential investors in either company would be wise to remember all the false bottoms we’ve seen in Valeant’s stock since it first started sliding.

Mylan has followed the Valeant playbook: buying a much needed drug and then rapidly raising its price. Because Medicare and Medicaid are often the ultimate payors, a large portion of these price hikes have been borne by American taxpayers. In Mylan’s case the product was the epipen, used to avert anaphylactic shock for folks with severe allergies. Mylan’s CEO, who is among the highest paid CEO’s in America, was criticized for this price gouging at a recent congressional hearing, but she has retained her job, and her eight figure annual compensation.

Wells Fargo had a multi-year program of ‘cross selling’ products, like credit cards, to customers who had not requested them. Last week longtime Wells CEO John Stumpf resigned over the scandal, but not before first blaming, and firing, 5,300 employees and the head of Wells’ consumer operations. I suspect these were not ‘rogue’ employees; just folks following an internal culture that promoted unethical and illegal behavior in order to stay employed. Thankfully, the head of the consumer finance protection bureau, Senator Elizabeth Warren, lambasted Stumpf at a recent Senate hearing.

In all three examples the time to sell was the day these scandals broke. Even today all three stocks should be sold, as headline risk persists. The Mylan story is far from over and Valeant continues to prove Charlie Munger correct when he called it a “sewer.”

As for Wells, I believe our government would have been well within its rights— per the Treasury Department’s oversight of all FDIC insured institutions—to place it under conservatorship, as it did with Fannie Mae and Freddie Mac after the 2008 financial crisis. The company’s stock would have zeroed out, and that would have put the entire financial services industry on notice that predatory behavior will not be tolerated. While a drastic step, I fear such action is necessary to prevent further abuse. Instead Wells’ investors, including Warren Buffett, have remained silent. It appears protecting the company’s share price is more important to these folks than treating American consumers and taxpayers fairly.

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Buy the Housing Dips

Nearly a decade after the financial crisis interest rates remain at zero. Fed watchers have been arguing for years that policymakers will soon raise rates, only to see the possibility put off yet again (and again and again). While many believe Yellen and company have stuck with ZIRP due to worries about the impact of a hike on the stock market, a bigger concern might be housing.  

In both 2004 and 2005 there were almost two million new homes built in America. That number dropped below 500,000 after the financial crisis. In 2016  almost one million single and multi family homes will go up. That’s good but not great, especially in light of fact that roughly 500,000 homes are torn down every year.

With rates at zero and the US housing supply reduced after years of below replacement construction, one would think housing stocks would be trading at historically high multiples of earnings and price-to-book levels. That has not happened, which continues to make select housing stocks extremely attractive.

Two favorites are Denver-based Century Communities (CCS) and Houston-based LGI Homes (LGIH). Both stocks have outperformed the group (and the market) over the last twelve months and both could easily continue to do so.

At $21/share, CCS is up 60 percent from its 52-week low, but is still below its $24 initial public offering in 2014. Century operates in five fast growing markets--Colorado, Atlanta, Las Vegas, Central Texas and Salt Lake City. Its average home price is in the mid-$300k vicinity. The company projects 2016 revenues in the $850M-$1 billion range, an estimate that will likely be tightened and probably raised after Century reports third quarter earnings in early November.

Wall Street projects Century will earn $2.50 and $3 in 2016 and 2017, so it currently trades at only 8.4x and 7x 2016/2017 earnings. Historically, Century has beaten Street guidance and I expect that trend to continue in 2016’s second half. An added bonus for Century shareholders might be the initiation of a quarterly dividend. The company already has a buyback plan, but it could easily initiate a .25 cent quarterly dividend, as it will generate over $100M in 2016 ebitda and has only 21 million shares outstanding.  

LGI is growing even faster. While LGI is headquartered in Houston, last quarter over half of its 1128 home closings were in communities outside of Texas. LGI’s average home price was an industry low of $197,450 last quarter, which means most of its customers are former renters buying their first homes. LGI projects 4,000 to 4,300 home closings in 2016, vs. 3404 closings in 2015 and 2356 closings in 2014. As I’ve written about before, its gross profit margin of 26.5 percent is the highest of all publicly traded home builders. LGI should earn $3.40 a share in 2016 and $4 in 2017, which means it currently trades at only 10.2x and 8.7x 2016/2017 eps.

I have interviewed the senior managements of both companies at their headquarters in the last two months. They are both run by smart, competent people who own sizeable amounts of their own stock (the all important ‘skin in the game’). Unless the US enters an unexpected recession soon, I expect continued rapid earnings growth and inevitable multiple expansion will help both outperform in the next twelve months.

[deadcompanieswalking]

It’s (Still) the Economy, Stupid

On Monday night, more than eighty million Americans watched our two candidates for president argue more about missing tax returns, deleted emails, and a former beauty queen than the issue that matters most to our country’s health and prosperity: economic growth.

When our economy grows rapidly, as it did during the Reagan and (Bill) Clinton administrations, good things happen. Home ownership increases, budget deficits shrink (Mr. Clinton produced a surplus his last four years), crime drops, and America’s influence increases worldwide. Unfortunately, our gross domestic product hasn’t grown more than four percent a year since the end of the last century, and I don’t see it topping that critical figure again anytime soon.

In both 2014 and 2015, US GDP expanded at a subpar 2.4 percent rate. The first half of 2016 was even more sluggish. GDP grew only one percent. While both George W Bush and Barack Obama inherited messes when they came into office—the terrorist attacks of 9/11 took place early in Bush’s first term and Obama had to contend with the fallout of the 2008/2009 financial crisis—each deserves a C-, at best, for their economic oversight.

I fear Hillary Clinton or Donald Trump will do no better. Hillary wants to increase personal income taxes, increase regulation of our fossil fuel industry, and keep the US corporate tax rate at 35 percent. Meanwhile, Trump’s anti-immigration rhetoric—immigrants, legal and illegal, start one-third of new businesses—and threatened trade wars could push our anemic economy into another recession. One wonders if Mr. Trump has ever read about, or even heard of, the ill-fated 1930 Smoot-Hawley tariff act and how it kick-started the Great Depression. I doubt it.

Here are seven straightforward tax and policy proposals that many economists agree would stimulate economic growth:

1) Lower the US corporate tax rate from 35 percent to the worldwide average of 20-22 percent and adopt a ‘territorial tax’ where offshore profits of US corporations are not ‘trued up’ to the higher US rate when those profits are repatriated. This would all but stop the ongoing inversions of corporate headquarters abroad and induce companies to bring offshore profits back to America. All told, S&P 500 companies now hold over $3 trillion in cash and earnings outside of the US, according to a recent report by Credit Suisse. Apple alone is sitting on more than $200 billion in offshore cash. Imagine how many jobs and opportunities even a portion of those enormous sums could create if our tax policy incentivized businesses to invest foreign earnings here at home?

2) Eliminate ALL income tax deductions. The US tax code was already a complicated mess almost forty years ago when President Jimmy Carter called it “a disgrace to the human race.” It’s far more complicated now. This leads to lower growth, ill-advised investment decisions, and money wasted preparing and filing tax returns. Contrary to popular opinion, most deductions benefit the upper middle and upper class. The ‘big five’ deductions are health insurance premiums, mortgage interest, state income taxes, charity donations, and retirement plans. Because every American already receives a standard deduction of $6300 for single taxpayers and $12,600 for married, these itemized deductions almost exclusively lower the tax obligations of the well-off while depriving the US Treasury of roughly $400 billion annually, vs. our total budget of $4 trillion.

3) Reduce the number of tax brackets from today’s seven to two or, at most, three. As importantly, the highest rate should be below 30 percent. Studies show that a higher top rate increases the likelihood taxpayers retire, cheat, or move away. While a single rate ‘flat tax’ sounds appealing, it is not equitable and more importantly is not politically feasible. I believe those who make large amounts should pay a higher rate than those who earn little. But I also believe the lowest rate should apply to most wage earners. Everyone needs ‘skin in the game.’

4) Adopt a balanced budget amendment. This would force politicians to stop (or at least slow) the explosion in our nation’s current $19 trillion in debt. Someday, possibly soon, investors worldwide will stop buying US bonds at today’s all-time low interest rates. When/if that occurs America’s annual interest cost will double to over $1 trillion. This will ‘crowd out’ other government spending, leading to a recession. Or worse.

5) Wind down Fannie Mae and Freddie Mac. These two quasi-governmental agencies, which purchase and securitize mortgage debt, exacerbated the 2008/2009 housing crisis. They could do so again as lenders make questionable home loans knowing they can quickly sell them (and book profits) to Fannie and Freddie. In her recent book Shaky Ground, author Bethany McLean wrote that many observers, including President Obama and former Fed chief Paul Volcker, support closing these entities. While this would increase mortgage rates from 1/4 percent to possibly one percent, it would stop the risk Fannie and Freddie pose to America’s taxpayers.

6) Fix Social Security and Medicare. Without changes, Social Security will deplete its current surplus within 20 years. Government economists believe recipients will receive, at most, 70 percent of promised benefits when that occurs. There are only three options to avoid this: reduce benefits, increase payroll taxes, or do a little of both. A start would be to ‘means test’ benefits, reduce cost of living increases, and lift the amount at which payroll taxes are collected. Fixing Medicare is more complicated, but we have to allow Medicare/Medicaid programs—which buy about half of all health services—to negotiate directly with pharmaceutical companies, medical device manufacturers, and other health care providers.

7) Offer Medicare to all American taxpayers. The current Obamacare hybrid is destroying jobs because it forces corporations to pay health care premiums for a growing percentage of their employees. Many have responded by hiring fewer folks. If a government health plan was available to all Americans (and everyone with income above a nominal amount could buy that plan, another plan, or pay a substantial penalty), corporations could shed the burden of providing health benefits and focus on what they do best.

From a nonpartisan perspective, these seven proposals are all strongly pro-growth, no-brainer reforms. Several of them were included in the Bowles-Simpson tax plan a few years ago. And yet, because the plan threatened many of the special interest groups that own our political process, both President Obama and congressional Republicans refused to embrace it. Voters, and taxpayers, deserve better.  

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Tech Stocks Are Still Seriously Overvalued

It’s may not be Pets.com-level crazy out there, but it’s not even close to sane.

Seventeen years ago, I had a front row seat for the nuttiest mania in stock market history. I vividly remember visiting now failed companies like Quokka Sports, Planet RX, Women.com, and Commerce One and listening to their managements confidently predict glowing futures. These firms, and many more, sold above 100x revenues--and they were far from the most overvalued stocks in the market. Other public dotcom companies had no revenues at all. Their stocks soared on nothing more than hopeful business models and lofty expectations of explosive growth.  

I was in the ninth year of managing my hedge fund in 1999. It gained 8 percent that year, badly lagging the S&P’s 19 percent return and the Nasdaq’s staggering 85 percent (!) gain. In March of 2000, the Nasdaq hit an all-time high of 5132.52. Then, on March 20th, Barron’s magazine wrote a much publicized article that listed every dotcom by its cash, monthly cash burn, and the number of months before each company would run out of money if it did not raise additional capital. There were 207 companies on that list. A large number went broke. Some of those flameouts, like Pets.com, live on in infamy. The majority of them are only recalled by hardcore stock junkies, especially those who got burned by their implosion.

Remember Be Free, ZapMe!, SmarterKids.com, drkoop.com, and MotherNature.com? Most investors under the age of 35 almost certainly don’t—and that’s a problem, because what happened to those businesses could easily happen to many of the new tech sector darlings. Far more companies in today’s public and private markets will probably become tomorrow’s drkoop.com instead of the next Amazon or Microsoft. And as we saw so vividly in 2000, when the end comes, it comes quickly.

By the end of 2000 the Nasdaq was down 39 percent, the S&P 10 percent. My fund was up 27 percent, as I shorted a variety of former highfliers based on visits with management and my belief that even companies that seemed well-positioned to survive (like Amazon, Doubleclick, and FTD.com, to name a few) could drop 25-50 percent or more in the ongoing Nasdaq collapse. Two years later, when the dust finally cleared, the Nasdaq was off 80 percent from its peak of 5000. Eighty percent.

Today, the Nasdaq is north of 5000 again and technology stocks are again leading the market higher. Many argue that things are different this time, and that tech names are not as excessively valued as during the late-1990s mania. They may be right, but I suspect any market selloff could easily hammer the tech sector as badly it did when the last bubble popped.

Take Facebook. Its market capitalization is $350 billion, vs. $18 billion in 2015 revenues. While FB has done much right, many people seem to overlook some glaring weaknesses in its business model. In the end, it is a well-managed advertising company operating in a business with limited barriers to entry. Remember My Space and Friendster? Both gone. While Facebook users are fanatical (the average FB user spends almost one hour a day on the service), many ‘heavy’ Facebook users are often ill-educated and have low household incomes. Not exactly an advertiser’s dream. Meanwhile, upstart competitors like Snapchat are already grabbing marketshare and many young people increasingly think of Facebook like I used to think of syndicated black-and-white television programs like Leave it to Beaver and The Honeymooners when I was growing up—as an outdated diversion. Instagram still seems to be popular, but I question its longevity, too, as well as its potential for long-term profitability.

Other tech and social media companies have rallied recently, and also are richly valued. Zillow trades at 9x 2015 revenues, Twitter 6x revenues, and Yelp at 5.5x revenues. None of these companies are buys. All could get cut in half in a meaningful market selloff. Like Facebook, they are essentially advertising companies. That means relatively low annual capital expenditures, but also lower barriers to entry than companies like Boeing, General Electric, Intel and even Microsoft. I started writing doubtful articles about Twitter’s future well over a year ago. Its stock was close to $50 then. Now, it’s below $20 and I still can’t see any earthly reason to buy the stock. For well over a year now, rumors have circulated about an imminent buyout. Now even Twitter insiders are openly admitting that they would consider being acquired—and yet no buyer has surfaced. It’s not hard to understand why. What’s hard to understand is why so many people believe that any company would pay more than $13 billion for a profitless business with poor management and flat-lining growth. That kind of magical thinking is the best argument that it isn’t “different this time.”

Compounding today’s valuation largesse, of course, is the number of still private companies with valuations above $1 billion. While new so-called “unicorns” aren’t being created as rapidly as they were in recent years, at last count there were still 133 of these behemoths out there. (By comparison, back in 2000, there was exactly one private firm valued above $1 billion.) If companies like Uber or its unicorn ilk ever do go public, any selloff in their stocks could drag the entire technology space lower, as well. But as valuations continue to swell and the prospect of profitability for most of these businesses continues to recede into the dim reaches of an imagined future, it’s increasingly hard to see how most of them can go public. Would stock investors really be willing to pay the cost it would take to exceed their gargantuan private market values? The answer to that question might end the debate over whether the current bubble matches or exceeds the craziness of the dotcom era.

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Happy Birthday to the Index Fund

The best thing to ever happen to investors is only getting better with age.

Wednesday marked the fortieth birthday of the most investor-friendly idea in stock market history: the index fund. Forty years ago Vanguard introduced the first fund that merely tracked the S&P 500. It has appreciated 6,334 percent since inception, trailing the S&P by a mere .14 percent annually, all of which was the ‘expense ratio’ charged investors. Few, if any other funds have matched or exceeded this annual return.

Today roughly $5 trillion is invested in index funds. Vanguard is the largest index manager, with over $3 trillion in assets under management (AUM). Other money managers now offer index products alongside their traditional, actively managed funds.  

Study after academic study shows that index funds outperform most actively managed funds. The reason is simple. Fees. The average expense ratio for actively managed stock funds is around 1.5 percent. It is somewhat less for fixed income funds. As Vanguard founder John Bogle has convincingly shown, a fund with a 1.5 percent annual fee (and the same pre-fee annual return) will produce a much smaller total return over a multi-year period than a fund with a .14 percent annual fee.

Investors have taken notice. According to the Wall Street Journal, they have invested $409 billion in passive index funds in the last year and pulled $310 billion out of actively managed funds over the same period. Roughly 20 percent of all money in stock funds is now indexed, up from zero 40 years ago.  

I suspect this trend will accelerate. America’s economic growth and thus profit growth will likely remain below historic levels for years. Economists predict US productivity growth and population growth will continue decelerating (see Northwestern economist Robert Gordon’s recent book The Rise and Fall of American Growth). Given that interest rates are already at zero, this scenario all but guarantees future market returns will be lower than the S&P’s roughly 9 percent annual gain since the end of World War Two. As this occurs, the outperformance by index funds vs. the average actively managed fund will be much more pronounced than in previous years.  

But don’t expect the asset management world to go down without a fight. A week ago, the reputable money management firm Bernstein issued a call to stem the indexing tsunami. The piece’s sensationalistic title--“The Silent Road to Serfdom: Why Passive Investing is Worse than Marxism”—was obviously meant to attract media attention, and paint Mr. Bogle’s invention in the worst light possible. I’ve seen this kind of scare mongering in the asset management industry for three decades now. When I started out, indexing was still in its infancy, but people in my business were already shading the truth about it, and for good reason: it represented a major disruption to our industry. Rather than acknowledging the clear benefits of that disruption to the majority of investors, many folks have chosen to demonize and misrepresent it instead. As Upton Sinclair famously said: “It is difficult to get a man to understand something when his salary depends on his not understanding it.”

I have always believed that most mutual funds and most hedge funds will underperform the indexes on an after-fee, after-tax basis. Results over the decades prove this. But I have also believed (and continue to believe) that a small minority of managers can, and will continue to outperform. The managers who accomplish this feat employ varying investment strategies, but they almost always possess a similar combination of traits: an above average IQ, some years spent working at firms with above average performance results, intense intellectual curiosity, a cynical frame of mind, and a mistrust of groups and group thinking (great investors are not joiners).

As importantly, consistently outperforming managers almost always avoid growing assets under management beyond an amount where outperformance becomes more difficult. While the optimum AUM varies by manager and by style, it is almost always under $1 billion. Most managers who solicit assets beyond that amount are amoral at best, dishonest at worst. The reason sub-$1 billion funds have a better chance of producing higher returns is obvious: pricing inefficiencies are likely greater in less liquid, less analyzed securities. A number of stocks I have written about over the years illustrate these inefficiencies, including homebuilder LGI Homes and apartment REIT Nexpoint Residential Trust. Both companies were barely followed by Wall Street when I visited with their managements, and far too small for larger funds to bother investing in—and both have far outpaced the indexes since I purchased shares.

A final warning to investors: as this industry disruption accelerates, the earnings, and stock prices, of asset management firms will likely disappoint. Some firms—those with low cost structures, low fees on actively managed funds, and a growing number of index funds/ETFs—will take marketshare and survive. But others may not. The list of publicly traded money management firms is lengthy. It includes household names like Franklin Funds, T Rowe Price, Legg Mason, Waddell and Reed, and Janus. Unless these firm adjust to the new index dominated world, their stocks could lag those very indexes for a very long time.

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Is It Time to Sample Stocks in These Two Dog-Eat-Dog Sectors?

Two of the roughest, most failure-prone sectors in the stock market have always been—and probably always will be—restaurants and retail. Competition is brutal in both spaces, margins are usually slender, and bankruptcy always seems to be one poor management decision away.

I’ve written about the slow-motion train wreck of the traditional retail sector fairly regularly over the last couple of years, and with several large operators like Nordstrom’s and Kohl’s posting surprisingly decent earnings lately, I thought it might be a good time to check back again. Could brick-and-mortar retail be on the brink a comeback?

Probably not.

Last week, job placement firm Challenger, Gray & Christmas reported that 43,600 retail jobs have been eliminated since January. One iconic chain after another, including Sears, Penney’s, and Macy’s have announced store closings. Teen retailers Pacific Sportswear and Aeropostale filed for bankruptcy in April and May, respectively, while Sports Authority went under in March and closed all of its 460 stores by June. This creative destruction is likely to continue.  According to Mark Cohen, the director of retail studies at Columbia University, “the traditional retail industry in some respects is facing Armageddon.”

The one/two punch of ecommerce and Amazon has left most brick-and-mortar retailers reeling. Amazon reported 2015 revenues of $107 billion, and is expected to grow to $137 billion in 2016. Amazon’s stock is up 13 percent year-to-date, 2446 percent over the last ten years, and a stunning 50000 percent since its 1996 IPO. The only retailers left relatively unscathed in its wake are deep discount concepts TJ Maxx, Ross Stores, and Dollar General. These chains offer ‘treasure hunt’ bargains that Amazon does not/cannot offer. (Some specialty firms like Louisiana-based Pool Corp, which I mentioned a few months ago, are also faring well.) Even with these few bright spots, for John Q Public, buying retail stocks, however inexpensive they appear, is an extremely risky and probably ill-advised strategy.

Restaurants could be a different story, however. There is no Amazon equivalent devouring the sector. Also, restaurants are benefiting from a favorable secular tailwind as well-managed chain operators continue to expand their marketshare. Many folks might feel a nostalgic fondness for mom-and-pop diners and other locally-based eateries, but chains hire better people, train them better, buy food at lower prices and understand that good, consistent menu offerings are the key to financial success. While my fund does not own any restaurant stocks today, my reluctance is due to excessive valuations, not long-term viability. Shake Shack, The Habit, Wingstop, Buffalo Wild Wings and the still private Five Guys are all great concepts with great growth potential. I am less excited about Cheesecake Factory (they are great operators, but the food is mediocre), Noodles, Pot Belly, and Del Frisco.

Personally, I am fascinated by restaurants. Maybe it’s because performing due diligence on them is a lot more enjoyable than analyzing an obscure software or biotech company. I own 50 percent of a successful nine-year-old Cajun restaurant in Berkeley, California. I have also invested in other restaurants (with my own money) over the last two decades. Some have done quite well. Some have crashed and burned. Investing in restaurants can be fun, but nerve-racking, because it doesn’t take a Chipotle-level scandal to bring on a sudden reversal. Consumers often simply tire of a concept. In recent weeks the 48-unit Fox & Hound, 23-unit Champs, and larger chain Logan’s Roadhouse have all filed for bankruptcy. Houston-based Ignite restaurant group, which owns Joe’s Crab Shack and Brick House Bar and Grill, is teetering on the edge of bankruptcy, as well.

Perhaps the most intriguing trend in retail and restaurants is the blending of the two. Chains like Ralph Lauren and Oxford Industries have profitable restaurants that help promote their larger apparel efforts. I recently bought 40,000 shares in Oxford Industries after visiting with its management. I believe its biggest brand–-Tommy Bahama—could grow at a double-digit rate after disappointing first quarter results. The coconut shrimp on its menu are pretty tasty, too.

[deadcompanieswalking]

Knowledge is Power

One of my favorite investing quotes comes from the legendary 1968 book The Money Game by George Goodman, aka Adam Smith: “If you do not know who you are, Wall Street is an expensive place to find out.”

I put this line at the beginning of my book because I’ve seen its wisdom proved again and again in my thirty-plus year career. As ironic as it sounds, the folks who start out in the investment business just to make money usually make less of it. The ones who do so because they’re inspired to learn as much as they can tend to make more. Of course, there’s nothing wrong with wanting to make money. We’re all trying to do that—the more the better. But if investing doesn’t fuel your intellectual curiosity, you’re probably not going to make as much money as you hope, and there’s a good chance you’ll go broke. 

I was talking energy stocks with a longtime money manager the other day and was shocked to discover that he did not know that most energy supply firms are headquartered in Houston. He guessed Austin, then Dallas. I was dumbfounded. Pick any article written about an energy company and it will almost certainly list Houston as its home city. The only explanation for this person’s ignorance is that he simply doesn’t read very much about America’s corporate landscape. That’s a serious problem for anyone trying to earn decent returns buying and selling the stocks of American corporations.

Sadly, he is far from alone. Many folks in my business display a stunning lack of intellectual curiosity. As I recount in Dead Companies Walking, I once gave copies of a fascinating book on small cap investing to a group of analysts and brokerage salesmen in a stockpicking game I was part of during the 1980s. I was excited to discuss the book during subsequent meetings. Those discussions never happened, because exactly none of the guys in the game bothered to read it. I doubt any of them even glanced at the first page. Incuriousness isn’t just an issue on the sell-side, either. A shocking amount of money managers display absolutely no knowledge of the various federal tax rates on capital gains, ordinary income, or dividends. I’ve talked to more than a few who could not even tell me the tax rates in their home states.

In the age of the passive index fund, it’s incredible to me that these sorts of people are still in business. It shows that far too many Americans are incurious about who is managing their money, too. They have no clue that most Wall Street firms promote wealth-destroying, rather than wealth-building activity. This includes overtrading, buying funds with high fees, and encouraging investors to hire expensive financial advisors who are often far less successful and affluent than their clients. As Warren Buffett once quipped, “Wall Street is the only place that people ride to in a Rolls Royce to get advice from those who ride the subway.”

Intellectual curiosity is the key to success in many endeavors, not just money management. For all of Donald Trump’s coarseness and braggadocio, his worst quality, in my opinion, is his puddle-deep understanding of the world. Even before he pledged to keep Russia from invading a country it has already invaded, it was already obvious that he didn’t care enough about acquiring and developing the knowledge necessary to become president. While I’m not a huge baseball fan, I constantly think about the book Moneyball (which became the best sports movie ever made, in my opinion). The way Billy Beane succeeded by bucking the orthodoxy of traditional thinking didn’t just take guts, it took brains, and a willingness to engage with new ideas. In football, Bill Belichick was widely criticized a few years back after going for it on fourth down deep in his opponent’s territory. The play didn’t work but it was actually based on sound mathematical reasoning. In fact, there is strong evidence that teams should never punt on fourth down. Of course, most coaches probably haven’t even bothered to read that evidence, let alone act on it, because they aren’t intellectually curious enough to do so.

There’s a reason Bill Belichick keeps going to Super Bowls while most coaches wash out after a few years—and it’s not because his quarterback is using deflated balls. It’s the same reason only a few money managers beat the indexes over the long term while most underperform or blow up their funds. Belichick is intellectually ravenous. He’s constantly devouring information and ideas. I don’t know what kind of money manager he would make, but I can guarantee you he would never squander his investor’s money by failing to keep up with changes in the tax code—and he would certainly know where every major energy company is headquartered.

Every year, I give a talk to investing students at Northwestern business school. I tell them that if they get into someone’s car to go to lunch and that person is listening to music on the radio instead of the news, there is a good chance they will fail at money management. The kids always look at me like I’m speaking a different language when I make this point. What does humming along to a few tunes on the radio have to do with successful investing? The answer goes back to Adam Smith’s line: if you don’t know who you are, Wall Street is a very expensive place to find out. This business is brutally hard and we only have a finite number of hours each day to acquire the knowledge we need to make good decisions. If you’re not hungry to do so, you might as well index your money and go watch some reality television. I’ve never seen it, but I hear a show called The Apprentice is fairly entertaining.  

[deadcompanieswalking]

The Year of the Gun

During chaotic times, it pays to sell a sense of safety and control.

Successful stockpicking is all about identifying profitable inefficiencies in consensus expectations for a given company or industry—and as much as I hate to say it, the mind-numbing spate of violence we have been living through this year probably makes the gun business one of the most undervalued sectors in the market today.

Tragically, I suspect the motivations behind many of the recent terrorist attacks abroad will lead to more violence. The philosophy ISIS offers is highly appealing to many young, often poorly educated homegrown European Muslims, and it is highly likely that more of them will choose the perceived martyrdom that follows killing “infidels” versus living on the financial, social, and cultural outskirts of their societies. That means more events like Nice (and Paris and Brussels). Meanwhile, here at home, recent assaults on law enforcement in Dallas and Baton Rouge might produce copycat attacks, despite the increased efforts by law enforcement to better serve inner city communities.

After each tragedy in the US, many pundits and some politicians are quick to blame our lax gun laws and easy access to firearms. Right or wrong, these public calls for a crackdown always cause a sharp spike in gun sales. Even though Americans already own more than 300 million guns, people fear legislation will soon limit their ability to purchase arms, so they rush out to acquire more. These buying sprees, in turn, trigger rallies in the stocks of two publicly traded gun companies, Sturm, Ruger (RGR) and Smith & Wesson (SWHC). Yet, despite this oft-repeated pattern, the firearms makers sell at a below market price earnings ratio of 15x and 18x estimated 2016 earnings, respectively.

These relatively low valuations are probably a sign that, like gun buyers, institutional and retail investors believe there is a chance, however slight, that gun sales will be constricted by the government at some point in the future. They might also reflect a negative association between gun manufacturers and other “sin” stocks like tobacco companies. But unlike cancer stick producers, whose revenues have been flattish for years (as a shrinking percentage of Americans smoke), gun industry revenues have been growing, and will likely continue to do so.

Over the years I, too, have been wary of investing in firearms companies. I have never owned Smith & Wesson or Sturm, Ruger and I’ve never traveled to meet with their managements. This gun-shyness has cost me a chance to earn some spectacular returns in recent months. Smith & Wesson is up 30 percent year-to-date. Sturm is up 13 percent. Thankfully, I have not missed out on another personal defense-related stock, Taser (TASR). I have interviewed Taser’s chief financial officer on multiple occasions at its Scottsdale, Arizona headquarters and I purchased shares in the company several months ago. The stock is up 50 percent this year and, with its dominant position in the body camera market for law enforcement agencies, I expect it to continue rising.

I am strongly considering stocking up on Smith & Wesson and Sturm, Ruger, too. The other night, a politically liberal friend of mine confessed that he was about to purchase a handgun. The constant news of violence had convinced him to put aside his qualms. I suspect he is far from alone. Furthermore, investor concerns about possible gun control legislation are likely overblown. Just as it was when Barack Obama was sworn into office, the industry will probably be helped, not harmed if Democrats win the presidency. While gun sales will almost certainly spike again as consumers worry about the prospect of new gun control laws, the actual chances of legislation getting through congress and onto Hillary Clinton’s desk are slim. Barring an electoral tsunami, the House will remain in Republican hands, and, rhetoric aside, Democrats have not shown a strong willingness to act on the issue. Bernie Sanders, who leans left on every social and economic issue, refused to speak out against gun ownership. And most congressional Democrats from Red State America know their constituents love guns, and love the Second Amendment, meaning opposing either would be a quick way to lose reelection.

Additionally, more ISIS-related attacks will almost certainly occur overseas in the coming weeks and months. Europe is facing a bleak future, both economically and culturally. Job creation and economic growth are nil, so the large and growing ethnic populations across the Continent—many of whom are Islamic—have little hope for upward mobility. On top of that, many are dismayed and repulsed by what they view as increasingly secular, morally decadent European lifestyles. That’s why it is homegrown Muslims—not first generation immigrants—who will probably carry out more atrocities in the months to come. That’s terrible news for the world, but it will boost the profits of American gun makers even more.

When people feel vulnerable, they’ll spend whatever it takes to regain a sense of control. And if the last half of 2016 is as chaotic as the first, companies offering that comfort—even if it is merely psychological—will do a very brisk business.

[deadcompanieswalking]

Tesla, SolarCity and the Race to the Bottom

Wall Street has always been captivated by controversial companies, controversial leaders, and controversial mergers. Tesla’s shocking offer to buy SolarCity on Tuesday featured all three, so it was no surprise that the deal instantly seemed like a bigger story than the presidential race, gun control, ISIS, and Brexit. It even managed to make the last controversial company that dominated headlines, Valeant Pharma, seem like an afterthought.

A few people have written in asking my opinion of the deal. The short answer is, I believe investors are well advised to avoid both stocks like the plague. As separate entities, these companies are wildly overvalued story stocks with a good chance of going broke. Together, they will form one wildly overvalued story stock with a good chance of going broke. 

SolarCity is run by two of Elon Musk’s cousins and has consistently lost money providing loans to folks to buy solar panels. I can’t see how an acquisition by Tesla would help this dodgy business model succeed. If anything, it could make things worse. A flurry of lawsuits will inevitably follow the deal, as ambulance-chasing lawyers will almost certainly accuse Musk of bailing out his potentially catastrophic investment in SolarCity with Telsa’s balance sheet.

I recently dined with the CEO of a solar installer. We had a fascinating discussion about the industry. The executive said that SolarCity could (and possibly should) go bankrupt and that it has a negative 25 percent margin on cash (not lease) sales that hurts other operators in the space. He also bemoaned the fact Wall Street, which loves fee-generating clients like SolarCity, fails to emphasize this glaring flaw in its reports on the company. Most intriguingly, he claimed that the recent extension of the investment tax credit for solar, which SolarCity supported, would harm, not help the industry. Why? Because it will unfairly keep struggling operators like SolarCity alive and allow them to continue to cut prices so that all companies in the sector lose money. 

Speaking of losing money, Tesla might be an even bigger mess than SolarCity. It sold a paltry 50,000 cars last year and lost almost a billion dollars in the process. It also has a mountain of debt. Most analysts, including Musk himself, believe Tesla needs to sell 300-400,000 cars annually to be a survivor in the brutal auto industry. To accomplish that massive leap in production, Tesla is counting on its recently announced Model 3, which the company is working to ship in late-2017 and will reportedly sell for about half of the current Model S’s $75-85k sticker price.

Setting aside Tesla’s enormously ambitious plans for the Model 3 rollout and its troubling history of issuing (and failing to live up to) overly optimistic guidance, two further issues may come to haunt the company. First, I’m not sure the cars it produces are as wonderful as everyone thinks they are. The Model X SUV has been an unmitigated disaster. And while the flagship Model S has a sleek design, one review said comparing its interior to an Audi A8 is like comparing a Burger King to Buckingham Palace. Second, the environmental benefits of an all-electric car may be less, perhaps much less, robust than the company claims.

Sure, some Tesla enthusiasts may be able to afford to clad their homes in enough solar panels to go completely “off the grid,” but the vast majority of car buyers still receive their electricity from traditional utilities, which means power comes into their homes largely from generation plants that rely on fossil fuels like coal, oil, and natural gas. Furthermore, the sizeable battery packs in electric cars lose capacity over time (estimates are 10 percent degradation annually), and eventually need to be discarded. While less polluting than nuclear fuel rods, those battery packs aren’t exactly green waste. They’re toxic. And yet, this issue is rarely discussed by the company or understood by Tesla buyers, many of whom reside in affluent, politically correct enclaves like Marin County, California. Despite the impressive number of pre-orders touted by Tesla for its Model 3, I remain doubtful that consumers outside of liberal bastions on either coast will buy the all-electric concept in big numbers.

Anyone considering buying Tesla stock in the wake of its announcement to acquire SolarCity would be wise to remember the other controversial, debt-laden company I mentioned in the opening paragraph. Not long ago, like Tesla, Valeant’s stock was soaring well above $200 a share as it made one acquisition after another. It only took a few months to crash to earth, though, after investors discovered that much of its business model was dependent on a scheme to overcharge payors, including Medicare and Medicaid. Valeant still has its defenders, most notably Bill Ackman, but the company’s once crowded bandwagon is getting emptier by the day.

I have no idea if Tesla and/or Valeant will someday go all the way to zero, but there is no denying that one or both very easily could. That fact should rightfully scare commonsense investors away. There are hundreds of better, safer options out there to be had—well-managed, dividend-paying company stocks with little or no debt and zero risk of going bankrupt. Real investment success is much more the product of minimizing losses than it is hitting “home runs,” which is what an investment in Tesla or Valeant would be if either stock rallies from current levels.

[deadcompanieswalking]

The Non-GAAP Craze Gets Crazier

Earnings, as the old Wall Street adage goes, are “the mother’s milk of stock prices.” But not all earnings are the same. More and more companies believe they can hoodwink investors into accepting the myth that non-GAAP earnings are a better measure of corporate progress than numbers produced by generally accepted accounting principles. In 2016’s first quarter, 19 of the 30 Dow companies reported both GAAP and non-GAAP earnings.

In theory, filing non-GAAP numbers can give a clearer picture of a company’s health by excluding expenses managements consider (or hope) to be nonrecurring, such as charges for divestitures, acquisitions, and foreign currency adjustments. In practice, non-GAAP figures increasingly allow managements to present wildly distorted pictures of their firms’ financial health by omitting the most troublesome aspects of their balance sheets. Valeant is all over the news now for doing just that. But the biggest and, mystifyingly, least talked about expense omitted in non-GAAP numbers is stock based compensation. 

For many technology companies, stock based comp is a massive liability: Twitter’s first quarter 2016 stock based compensation was $151M, a staggering sum vs. Twitter’s $595M first quarter revenues. This albatross largely explains why Twitter reported a first quarter GAAP loss of $80M yet posted first quarter non-GAAP net income (or, rather, “income”) of $103M. Analysts expect Twitter to have $700M in full-year 2016 stock based comp, or almost 25 percent of estimated 2016 revenues.  

According to Factset Research, 2016 first quarter non-GAAP earnings were 29 percent higher than GAAP earnings for all US companies that reported both numbers. In 2015’s first quarter, non-GAAP earnings were 20 percent higher than GAAP earnings. This growing emphasis on non-GAAP earnings masks a troubling trend: corporate earnings, the “mother’s milk” of stocks, are shrinking.

In 2015, S&P 500 GAAP earnings fell below $100 per share, down from $104 in 2014. Earnings are estimated to fall further in 2016. They dropped 4 percent in the just-finished first quarter, which marked the fourth consecutive quarterly earnings decline. Revenues also fell, and are projected to drop another one percent in 2016’s second quarter. Combine this downward trend in earnings with the inevitable fact that the Fed will eventually raise rates again, and it’s hard to feel positive about the outlook for stock prices.

As the S&P has recently inched its way back toward 2100, the market’s price-earnings ratio has also moved higher. If S&P 2016 GAAP earnings are $90 per share, then the market is now selling at a nosebleed 23x. Worse, select technology companies (like the FANG stocks anointed by TV pundit Jim Cramer over a year ago) sell at vastly higher valuations, which means downside risk is large, even for relatively strong businesses like Google and Facebook. Shaky companies like Twitter, which is a nifty service but a questionable business, could fall much further when/if a widespread market selloff occurs.  

Twitter has over $3 billion of cash, but also nearly $2 billion of debt, and advertisers are second guessing the value of advertising  on Twitter and other social media sites. Just a few months ago Wall Street analysts predicted Twitter’s 2016 revenues would be $3 billion (almost all from ads), vs. $2.2 billion in 2015. Today analysts predict Twitter’s 2016 revenues will be below $2.7 billion. If Twitter has a 26 percent ebitda margin (the company only gives full year ebitda and capital expenditure guidance), the company’s full year ebitda will be about $680m or around $1/share. Less capital expenditures of $300-$425M, Twitter will once again produce less than 50 cents/share in free cash flow. Its stock, short of an acquisition, could get cut in half again.  

Though I see value in its service, I remain baffled why anyone would own Twitter’s stock. I can only assume that many of its investors are true believer users. This blind allegiance reminds me of people who have been in psychotherapy for decades. They happily fork over huge amounts of money to some dodgy guru who probably attended a third rate university, all the while boasting about the benefits they are reaping from the process. Meanwhile, their wallets keep getting lighter and lighter.