April 30, 2013
by Jeffrey Saut
of Raymond James
Zebras have the same problem as institutional portfolio managers. First, both seek profits. For portfolio managers, above average performance; for zebras, fresh grass. Secondly, both dislike risk. Portfolio managers can get fired; zebras can get eaten by lions. Third, both move in herds. They look alike, think alike and stick close together. If you are a zebra, and live in a herd, the key decision you have to make is where to stand in relation to the rest of the herd. When you think that conditions are safe, the outside of the herd is the best, for there the grass is fresh, while the middle see only grass which is half-eaten or trampled down. The aggressive zebras, on the outside of the herd, eat much better. On the other hand – or other hoof – there comes a time when lions approach. The outside zebras end up as lion lunch, and the skinny zebras in the middle of the pack may eat less well but they are still alive.
… Acorn Fund’s founder, and portfolio manager, Ralph Wanger
We saw many “outside zebras” gorging themselves on stocks in late 2007 as the D-J Industrial Average (DJIA) made a new all-time high and then registered a Dow Theory “sell signal” in November 2007. Subsequently, those outside zebras ended up as “lion lunch” when the senior index shed an eye-popping 53% over the ensuing 17 months. By March of 2009 many of those outside zebras had moved to the inside of the herd just in time to miss the bottom. Since those lows, more and more zebras have ventured back toward the “outside” of the herd driven by performance pressures. I have repeatedly commented that given the immense amount of cash still on the sidelines, as the equity markets continue to rally, the performance pressure, subsequent bonus pressures, and ultimately job pressure become just too great, causing portfolio managers to “pay up” for stocks. And that, ladies and gentlemen, is why the corrections have been short and shallow since the November 2012 “lows.” As the Jeremy Grantham writes:
In markets, where investors hand over their money to professionals, the major inefficiency becomes career risk. Everyone’s ultimate job description becomes ‘keep your job.’ Career risk-reduction takes precedence over maximizing the client’s (portfolio) return. Efficient career-risk management means never being wrong on your own; so herding, perhaps for different reasons, also characterizes professional investing. Herding produces momentum in prices, pushing them further away from their fair value as people buy because others are buying.
Clearly, this performance pressure is currently playing on the “street of dreams” as the D-J Industrials (INDU/14712.55) and the D-J Transports (TRAN/6115.89) have tagged new all-time “highs” over the past few months (yet another Dow Theory “buy signal”). Accordingly, I revisit Ralph Wanger’s “Zebra” story this morning having returned from the RJFS National Conference, where I interfaced with a number of portfolio managers (PMs) that are currently experiencing the same “performance pressures” that many investors are feeling, having missed the recent rally. Yet one of the most frustrating comments came from a PM that was almost fully invested, but is still woefully underperforming. His problem is he is fully invested in U.S. companies that generate more than half of their revenues outside the United States (Internationals). Surprisingly, companies generating more than 50% of their revenues inside the U.S. (Domestics) are outperforming the Internationals by a wide margin, as can be seen in the chart on page 3 from the sagacious Bespoke organization. Indeed, the Domestics are better by 21.3% over the last 12 months while the Internationals are up only 8%.
One company playing to this Domestics theme is Rite Aid (RAD/$2.54/Outperform). RAD has new management, is a real estate play, has in store clinics, and our analyst (John Ransom) thinks it can have a billion dollars in cash flow in 2015. While John projects only moderate price appreciation near term, over the next few years, as the turnaround takes place, he thinks the shares could trade meaningfully higher. As John writes in his company comment of April 12, 2013:
We are upgrading shares of RAD to Outperform from Market Perform … We believe that FY14 guidance (i.e., flat EBITDA) looks conservative and the company will start to generate meaningful free cash flow (FCF) in FY14, reaping the benefits from its recent refinancing. While we acknowledge y/y pressure from the lapse of the Lipitor and Plavix generic exclusivity period and from a (still) leveraged balance sheet (5.3x EBITDA), RAD will continue to benefit from deleveraging, debt refinancings (including $800 million in callable debt in May at 9.5%), script growth, its burgeoning loyalty program roll-out, file buys ($60 million per year), and store refresh initiatives, which should help buffer the aforementioned headwinds. We believe that RAD will generate ~$0.27 of FCF/share in FY14 ($0.36 in FY15), and that FCF growth should average 10-20% over the next three years, assuming modest EBITDA growth.
RAD also plays to one of the best performing industries of the year (Drug Retailers +20.03% YTD), as well as one of the better performing macro sectors. To be sure, the Consumer Discretionary sector has been the third best performing sector year-to-date at +14.60%, while Consumer Staples is second (+15.61) and Healthcare is first (+19.60%) driven largely by the Biotechnology industry (+34.80%). Moreover, since we are in earnings season it is worth mentioning that of the 855 companies in the S&P 1500 that have reported, 59% have beaten the earnings estimates and 49% have bettered revenue estimates. Drilling down into the macro sectors, those showing the highest “beat rate” finds Consumer Staples first with a 69.6% beat rate, followed by Consumer Discretionary (+65.2%), and Information Technology (+63.5%).
As for the overall stock market, today is session 82 in the now legendary “buying stampede” because the Industrials have not experienced as much as a three consecutive session decline since the back-to-back 90% Upside Days of 12/31/12 and 1/2/13. At the time I was writing that such back-to-back sessions have left the INDU up 12.8% three months later 100% of the time; and while we didn’t quite achieve that this year, we certainly came close. Last week’s rally occurred from marginally oversold levels with the Buying Power Index rising while the Selling Pressures Index fell. Buying has also been broad based with all of the Advance/Decline metrics I monitor reaching new bull market highs. In summary, the data suggests the equity markets have once again dodged the opportunity to correct in any meaningful manner; and I must admit, I have NEVER seen anything like what has occurred since the “buying stampede” extended beyond the previous record of 53 sessions! That said, my work continues to suggest the equity markets do not face a period of serious vulnerability until this summer, unlike the last three years where “Sell in May and go away” has played so well, provided you redeployed the cash raised in the spring to stocks sometime during the summer months. I don’t think the scenario plays that way this year.
The call for this week : This week will see a large 29 different economic indicators released with the most important being the ADP employment report, initial unemployment claims, the monthly non-farm payrolls report, the Chicago PMI, the ISM Manufacturing report, and the ISM Services report. Such a deluge of economic data within a one-week time period is fairly rare, so buckle up. All such reports can be market moving, but so far the bears, rubbing their collective hands together with glee over the fiscal cliff, sequestration, the continuing resolution, the debt ceiling, etc., have been totally w-r-o-n-g. I feel sorry for the bears waiting for the “crash” they have been expecting for the past four years all to no avail. It looks to me as if the stock market will continue its move irregularly higher until we get indications that something is irrevocably wrong. So far, nothing in the stock market’s internal structure has told us to be anything more than cautious, but NOT bearish.
© Raymond James