This week Robert Swift takes a look at a portfolio holding which has gone from under-performer to outperformer. He digs into the importance of conducting proper analysis and, if nothing changes, having faith in it to work in the long term.
If you have any interest in investing, then Moneyball is a book worth reading and a film worth watching. It is the story of a relatively poor Baseball team, the Oakland Athletics and how in the early 2000s they competed successfully against the bigger spending teams such as the New York Yankees and (my team) The Boston Red Sox.
Using some novel techniques to measure real worth in a baseball player, (Sabermetrics) and a team based approach (risk control) they managed to punch way above their $ weight and come close to reaching the World Series. So successful were they that the techniques and staff were then poached by the bigger clubs.
The relevance to investing is that the worth of a stock (or player) doesn’t have to matched by its price (or salary) and the difference can be exploited successfully. You can spend a lot less than you need to, and get a better team or portfolio as a result. Additionally, the way in which you combine cheap misfits (value stocks) into a functioning team (portfolio) can result in performance which is better than simply adding the individual statistics. A pitcher with a high Earned Run Average (ERA) can actually get a lower ERA and be a lot better, if he has a catcher who calls the correct pitches to be thrown at the right time. Matching the two in a team (portfolio) produces better results than either alone looks capable of achieving. This is kind of what the Oakland Athletics did and what good portfolio management should do. Seek stocks whose prospects are overlooked by the market and then use a portfolio approach to mix the attributes onto a better outcome. Like the A’s we prefer stocks which are cheap and held in low regard, rather than going to the obvious, highly promoted, well buffed, (and overpriced) ‘stars’.
Sabermetrics as analysis has moved on because once copied, it became clearer who the better value players were and the correct way to judge them. Their prices rose and the mistakes in pricing became fewer. Once ‘On Base Percentage’ (OBP) became the preferred metric for a hitter, Home Runs, although glamorous, became less coveted. In the same way you have to be prepared to tweak your investment process because once other people do what you do, the pricing mistakes get fewer and fewer and you have to find a new edge. Someone once likened portfolio management to baseball which we think is a good analogy. The season (track record) has to be long to judge true skill; the difference between a winning and losing season is about 10 games out of 162 played. Win those 10 and you get to the play offs; lose them and you don’t. If you can eliminate 10 bad stock picks out of hundred made, then you are doing well; really well. You also have to be prepared to change tactics and team members, and then sometimes not.
Let’s move on to talk about Macy’s and why it would be a candidate for the A’s, but first check out some of the you tube footage for some of the ’weird pitching styles’ that were so unorthodox, so cheap to hire, and yet so successful for the A’s. This is of Chad Bradford who actually went from the A’s to The Red Sox who also pinched the Sabermetrics.
Interestingly the owners of the Red Sox then bought Liverpool FC and have tried similar statistical analysis in Soccer (Football) .
Macy’s as a portfolio candidate was generated by our VMQ model (Like Sabermetricians we have our own way to assess likely candidates) which highlighted the stock as very attractive about 2 years ago.
We had zero direct exposure to the USA consumer at the time and were well aware of the problems with physical retailers and the Amazon, Alibaba, ASOS on line threat, and the absence of a level playing field with respect to income tax, property tax, and sales tax.
We invested because we thought we saw a company with a decent plan to deal with these threats and enough of a cashflow and balance sheet cushion to survive further competition and any delay in profits from their new formats.
It was a typical Value pick at first. Not a lot of movement in news flow or stock price and then a plethora of negative articles from the last remaining bears on the stock which was stupid money exiting. This was painful because we had to watch as the share price fell in response to this ‘analysis’ which failed to acknowledge that the metrics used to judge success for an expanding store count and square footage, would be irrelevant. Same store sales were bound to be under pressure as the company shrank leased space, reduced inventory lines and refused to discount on the main floor, but sales per employee were rising and the increase in foot traffic generated by new initiatives such as the bluemercury spa centres, was very clear, at least to us. We looked at Macy’s OBP rather than its Home Runs. We were too early but this is a standard challenge for a value style investor. We keep fighting against this temptation, as we do against selling too early, but the rapidity with which the share price rose when some good news emerged meant we may not have been able to get set if we had waited for the news flow to improve.
(Sometimes it makes sense to buy into a falling price, because the transaction costs of doing this are much lower. We have managed $billions in portfolios and know from experience that buying large $ amounts of stock into rising prices can pretty much make the investment futile. It is not relevant to this article but transaction costs for value style managers are a competitive advantage vs growth style managers)
Now Macy’s is at $29 and has touched $30 recently, we like it more than we did at $19! Simply because we are happier now that others recognise it is not headed to zero. This trend in market perception we pick up in ‘M’ our momentum part of Sabermetrics.
JCPennys and Sears are more like Myer in Australia – high debt levels constrain any strategy to deal with the changing environment. Macy's has strong asset backing with a NAV over $50 at least; strong and persistent free cash flow of about $1bn p.a.; a solid dividend yield of over 7% and so we could afford to be patient. We weren’t concerned about the traditional metrics being used to judge retailers because they are not relevant once a retailer starts reducing store and head count and space. New strategies take time to build sales momentum and so it was always likely that the market would make a mistake.
Our mistake was that we were too early; but we did the right thing in believing our analysis.
What did we find attractive?
Macy's is a top e-commerce retailer in terms of revenue. The CFO Karen Hoguet stated that Macy's has seen 34 consecutive quarters of double-digit e-commerce growth. Amazon, everyone’s favourite, and the #1 e-commerce retailer, has a current market value of $722 billion, with annual sales of $177 billion and declared net income of $3 billion. Amazon is being valued at > 4 x revenue and >2OO x P/E. If Macy's were valued like Amazon, its $5 billion of e-commerce sales would be worth $20.3 billion, or about $60 per share.
Amazon also regularly issues in excess of 1 million shares to employees as compensation each quarter, which means it is issuing $1.5-$2.0 billion of shares each quarter. Macy's meanwhile reduces shares outstanding and has also been paying down debt with its cash flow. At a time when we anticipate that interest rates will rise, and that debt rollovers will be problematic for some companies, we like this ability.
So what else is there within the Macy’s portfolio to like?
Solid asset backing and a ready supply of willing buyers for it. Its three trophy properties - Herald Square in New York City, State Street in Chicago, and Union Square in San Francisco - have been repeatedly claimed to be worth upwards of $7 billion, nearly equal to the entire Macy's market cap today. Macy's has generated $1.3 billion of cash from the sale of excess and underutilized real estate over the past three years, and it still has a treasure trove of real estate left. Macy's has a joint venture in its properties with Brookfield Asset Management. Between its trophy properties, its partnership with Brookfield Asset Management and its nearly 500 remaining stores, it is not difficult to see all of Macy's real estate being worth $12-14 billion, and possibly more. Using $10 billion as a guesstimate, Macy's real estate is worth >$30/share, far more than the current stock price. At this juncture we should contrast the Macy’s real asset backing with the parlous state of the Myer balance sheet. Effecting a turnaround requires a strong balance sheet which can be used to free up capital to reinvest in better businesses. Myers has this challenge which Macy’s does not. We also note that Sears, a USA competitor of Macy’s has a highly leveraged balance sheet too, and very little collateral. We wouldn’t think of investing in these even though they appear cheap. They are not.
All this and the top line is growing too.
There is clear evidence that management can grow the top line rather than continue to use asset disposals to maintain profits and dividends. Macy's management acquired and then built a beauty and spa business. This rapidly expanding business, is now > 150 stores today from 62 stores in 2015. bluemercury has a publicly traded competitor, Ulta Beauty. Ulta Beauty was founded a decade before bluemercury and has over 1,000 stores, with a growth plan to scale up to 1,600 stores domestically, and potentially more should it go international. Ulta Beauty has a market value of around $12 billion.
Bluemercury has shown faster same-store sales growth rates than Ulta Beauty but If we simply use one-tenth the market value of Ulta Beauty we could say bluemercury is worth >$1.0 billion, or $3-4 per Macy's share?
Overall, the valuation still looks compelling and the prospects brighter. The P/E is around 10x with a 5% dividend yield. Amazingly, last November, when Macy's was trading at $17.50, the dividend yield was 8.6%, with investors betting on a dividend cut, even in the face of management stating it had no intentions of cutting its dividend or the fact that free cash flow easily covered the dividend payments. Since then we received a nearly 9% yield and have a 75% gain on entry price.
Recent USA tax changes will really benefit USA based entities which cannot aggressively manage tax affairs offshore, as Amazon does, and hoard cash. JC Penney and Sears will become weaker competitors and thus allow Macy’s better pricing power. Macy’s could simply be re-rated with management having proven that the asset base is sound, the cash flow is persistent, and that new initiatives are working.
Maybe if it renamed itself ‘Block chain Macy’s’ we could get to fair value, or higher, quicker? Such is the (thankful) stupidity of markets
We went to the USA recently and visited some of the Macy’s store range in the North East. We are well aware that such a small sample can be misleading but noted the following and were pleased:-
In our global portfolio we could view Macy’s as the closing pitcher with the weird action, or the overweight catcher, or the lead off hitter with the most walks to first base rather than hits, but within the context of the other stocks, or team members, we own, it has a place; has performed and will continue to perform well. Sometimes the best way to play is to do what others don’t?
Markets & Commentary
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TAMIM Asset Management provides general information to help you understand our investment approach. Any financial information we provide is not advice, has not considered your personal circumstances and may not be suitable for you.