Selling Too Early: When Focusing Too Much On Valuation Punches Back Hard

The longer you invest in the public markets the easier it is to identify your past mistakes. While these errors have cost you some money before, hopefully you can learn enough to reduce those losses in the future. Until I reach an age where my memory starts failing me, the cases where I sold too early will be a constant (positive) reminder that getting too worked up about near-term valuations for stocks with excellent long-term outlooks can result in leaving a lot of money on the table.

Back in 2011 I lived in Pittsburgh where my now-wife was getting her PhD. A short stroll from our apartment was a fellow RIA (hat tip to Ron Heakins with OakTree Investment Advisors - hope you are doing well my friend) who organized regular meetings with local investment advisors to share ideas and stay on top of an ever-changing industry. I recently came across a brief PowerPoint slide deck I shared with the group back then over a weekend breakfast meeting at Bruegger’s Bagels. In hindsight, it exemplifies how selling too early for not the best reasons can cause heartburn down the road.

You can view the 5-slide deck on AutoZone (AZO) here and I will summarize it below.

The investment thesis was fairly simple. AutoZone held a strong position in a mature, economically insensitive industry and was using its prodigious free cash flow to conduct massive share repurchases (in lieu of taking the more tax inefficient dividend route). The ever-smaller share count helped AZO turn 7% annual sales growth into 22% annual earnings growth from fiscal 1998 through 2011, propelling the stock price to 21% annualized gains during that time (to $325 per share by late 2011).

Since I thought the trend was likely to continue, it was a worthwhile idea to share with our group. Simply put, AZO appeared to be a wonderful buy and hold stock and with the economic uncertainty still lingering in 2011 from the Great Recession, the business outlook appeared quite resilient regardless of where we were in the business cycle.

I can’t recall when I sold the stock after that, but I can tell you it has been an “on again, off again” investment during the ensuing 13 years for me and my clients, largely due to peaks and troughs in the stock’s relative valuation even as the core underlying story has remained unchanged the entire time. In hindsight, that was not the right call. The correct move was to simply buy and hold.

Despite AZO stock compounding at 21% per year from 1998 through 2011, the 2012-2024 period has seen similar performance, with the shares compounding at 20% per year to the recent price of $3,100. Trying to exit when it was overbought and add when oversold not only added more work than was needed, but also undoubtedly resulted in lower returns over the long term. Lesson learned.

Full Disclosure: No position in AZO at the time of writing, but positions may change at any time

Shares of Coffee Giant Starbucks Look Appealing After 5-Year Lull

With shares of Starbucks (SBUX) trading around 2019 levels (low 90’s) despite sales and free cash flow that are running well above pre-pandemic levels, I am getting close to boosting my firm’s exposure for my clients. With both a P/E and a P/FCF multiple in the mid 20’s, SBUX fetches a price at the low end of historical valuation ranges despite a competitive position that remains as strong as ever today.

5 Year Price Chart of Starbucks SBUX Stock (2/5/24)

The recent stock price weakness can be linked to negative press (a small but growing subset of stores whose workers believe unionizing is the answer to their prayers), as well as ever-rising retail pricing driven by underlying inflation that threatens to reduce consumer visits.

The first concern seems quite manageable given the overall size of the company. A few hundred unionized stores out of nearly 20,000 total in North America will hardly bite the company’s income statement. I believe the union momentum is likely slowing due to unimpressive results thus far (the two sides have yet to come to an agreement on a contract despite months and months of back and forth). The strongest evidence that disgruntled SBUX employees are simply looking for a scapegoat becomes evident when the media presses them on why they don’t simply quit and work somewhere else. After all, if SBUX treats their employees so badly relative to other chains, a mass exodus of good workers would probably be quite successful in getting SBUX executives to play ball.

Interestingly, the union hopefuls respond to such suggestions by pointing out that they can’t make as much money elsewhere and the benefits aren’t as good. This is true, of course, relative to smaller, more local coffee shops nationwide, but it blunts the impact of their pro-union arguments in almost comical fashion. Basically, SBUX is a better place to work than most other food service companies, but since they can’t get everything they want, they’re going to unionize. I suspect this flawed logic (they don’t really have any negotiating leverage) is why the vast majority of SBUX workers have not pursued a union vote and seem generally happy with their jobs.

The concern of inflation is always real, as SBUX has been forced to raise prices materially like everybody else in recent years. But for decades now the SBUX customer has generally seen the product as a relatively affordable luxury and regulars keep coming back during the ups and downs of most economic cycles. It is hard to see that trend changing now, after it withstood the Great Recession and the pandemic. As a result, the odds that SBUX continues to be a mature, dominant food service business with cash-cow characteristics for many decades to come appear quite high.

All in all, I view SBUX as a phenomenal business that currently trades near historical troughs in valuation terms (I went back about a decade to make that assessment). Don’t get me wrong - it’s far from dirt cheap, but great businesses rarely are, and buying high quality at very reasonable prices has served long-term investors very well over the long term.

Full Disclosure: Long shares of SBUX personally and for some clients, with the latter group likely to see larger purchases in the near future.

MBIA Shareholders Laugh Efficient Markets Hypothesis All The Way To The Bank

As an active manager of debt and equity investment portfolios it will come as no shock that I do not believe in the efficient markets hypothesis (EMH).

From Investopedia.com:

The efficient market hypothesis (EMH), alternatively known as the efficient market theory, is a hypothesis that states that share prices reflect all available information and consistent alpha generation is impossible. According to the EMH, stocks always trade at their fair value on exchanges, making it impossible for investors to purchase undervalued stocks or sell stocks for inflated prices.

While there are numerous examples that clearly debunk EMH, periodically we stumble upon one so prodigious that it is worth sharing. This week that example is MBIA, an insurance comapny that is seeing its share price rise by a stunning 75% today alone:

What makes this stock, which closed yesterday at $7.38 worth nearly $13 today? A special dividend announcement from the company itself:

You read that correctly - an $8.00 per share dividend to be paid two weeks from now. You don’t see that kind of announcement every day for a $7+ stock.

Full Disclosure: No position in MBIA shares at the time of writing (unfortunately)

Is Total U.S. Credit Card Debt Really Over $1 Trillion and Should We Be Concerned?

Recession forecasters tend to jump on any financial datapoint they can find to justify their predictions of imminent financial doom and one of the those that bothers me the most is definitely our “record level of credit card debt.”

Here is a chart from a CNN article over the summer titled Americans’ credit card debt hits a record $1 trillion:

Before we get too concerned, consider the following:

1) Credit card “debt” is measured by simply combining all of the balances of every active card in the U.S. at any given time. So, if you use a credit card for everyday spending in order to get rewards and delay the cash outlay for the stuff you buy, that is considered “debt” even if you pay the balance in full every month and never owe a dime of interest. Considering how many people do this every month, and what percentage of overall credit card spend would come from such consumers, it is highly misleading to characterize every dollar of credit card balance each month as “debt.”

2) The financial media usually highlights the total amount of this so-called debt because it’s a big number. $1 trillion!!! Far more helpful would be per-capita data since the country’s population grows each year. If you don’t make that adjustment, most years will be a new record high.

3) As many financial professionals out there know, debt is one thing (sorry, for this one I am going to pretend the entire $1 trillion+ is debt) but what really tells the story of overall financial health is both assets and liabilities, income and expenses. Having debt is not a big deal (sometimes even quite beneficial) if your assets and income can easily support it.

With those ideas in mind, let me reframe the chart shown above to put credit card “debt” in better context:

a) Although total credit card balances have grown by 56% from 2013-2023, the U.S. population has grown by 24 million people during that time. Thus, on a per-capita basis, credit card balances average $3,029 per person in 2023, up only ~45% since 2013 ($2,089 per person).

b) As previously mentioned, the $3,029 figure does not represent true debt like a student loan or auto loan balance would. I don’t have data to indicate what fraction of card balances are carried over month-to-month, but it is safe to assume it is materially lower than $3,029.

c) How do we know if credit card spending has really been growing at problematic rates? Easy, let’s look at income data. According to the U.S. Department of Housing and Urban Development, median family income nationally has grown from $64,400 in 2013 to $96,200 in 2023 - an increase of 49%.

To summarize, $1 trillion in total U.S. credit card balances might appear to be concerning in the absence of any other information. If we adjust the data for population growth and compare it to income growth, we see that over the last decade incomes have risen 49% while credit card balances have risen 45%. Additionally, as credit card rewards programs have become more engaging over the last decade, it has become more common for consumers to use cards as a way to benefit financially by using them for most purchases and paying their balances off each month.

And so, there doesn’t appear to be a credit card debt problem at all.

That is not to say we will avoid a recession in 2024 (nobody knows that) - but rather simply that credit cards will not be a contributing factor if we don’t.

Big Tech Valuations Are Greatly Skewing the S&P 500's Overall Valuation

With the benchmark 10-year government bond rate now yielding around 5% it can be a bit disheartening for equity investors to see the S&P 500 fetching about 19 times earnings. At best, future upside in price is likely going to need to come from profit growth, not multiple expansion. And if a recession materializes in 2024, prompting a material decline in multiples, well, look out below.

That’s the bad news.

The good news is that the big tech sector has grown to be such a large portion of the overall market that non-tech stocks actually aren’t richly priced at all, even in the current interest rate environment.

Consider the 7 largest tech stocks in the market - Apple, Microsoft, Amazon, Alphabet, Nvidia, Tesla, and Meta Platforms. Together they comprise 28% of the market cap weighted S&P 500 and sport a blended P/E ratio of 37x. Some simple algebra tells us that the rest of the market (the remaining 72%) carries a blended P/E ratio of just 12x. That latter figure makes sense considering stocks generally are well off of their all-time highs and rate increases have clearly been a headwind over the last 24 months or so.

The analysis remains consistent if we expand the calculation to include more of the tech sector. Information technology alone (excluding communications services - which is a separate S&P sector designation) comprises about 27% of the cap-weighted S&P 500 and sports a 29x P/E ratio. Doing the same number crunching shows that the remaining 10 sectors of the index combined carry a P/E ratio of just 16x.

If we try to determine what “fair value” is for the U.S. equity market given the 5% 10-year bond rate, most market pundits would probably say somewhere in the “mid teens” (on a P/E basis) based on historical data. In that scenario, 19x for the entire S&P 500 seems high, until we consider that tech stocks account for the elevated level overall. Exclude tech and (depending on your preferred methodology) everything else trades for a low to mid double-digit earnings multiple - which certainly makes it easier to sleep at night. It also likely explains why there are no shortage of attractively priced stocks outside of the high flying tech names that most people focus on. That’s probably the best place to focus right now as a result.

Is Cava Group the Next Chipotle Mexican Grill?

Long-time reader Zach writes in asking if Mediterranean fast casual restaurant chain and recent IPO Cava Group (CAVA) “is the next Chipotle?”

I think there are two core questions here; 1) does Mediterranean cuisine have the same mass appeal and guest frequency potential as Chipotle, and 2) can management execute a rapid growth nationwide rollout without making major mistakes (the chain plans to grow from under 300 locations to 1,000 over the next ten years).

If I were contemplating investing in CAVA (I’m not currently) I would be more concerned with #1 above, even though both are core risks. Let’s see how the stock market currently values CAVA stock, to get an idea of whether the bar is set high for its future growth potential:

Much of Chipotle’s success has been due to extraordinarily low build out costs relative to the sales volumes and unit-level margins the locations deliver. I believe CMG has the highest four-wall profit margins of any publicly traded dining company. That said, CAVA’s 26% in Q2 of this year is pretty darn solid. I would be concerned about volatility on this metric though, as the company currently projects only 23% for the full year 2023 and last year was more like 20%. Chipotle has been much less varied.

I would point out two more things when it comes to the quantitative comparisons above. First, much of CMG’s outstanding stock market performance has come from multiple expansion (2x price to sales post-IPO to more than 5x price to sales today). Conversely, CAVA stock today already fetches more than 6x sales and has only traded publicly for 2 months. The potential for similar multiple expansion simply isn’t there - which means they will have to grow units quickly and maintain volumes and margins while doing so in order to impress investors.

Secondly, notice that the market is valuing each existing CAVA location more than each Chipotle unit, despite CMG outposts earning about 20% more in profit dollars. Has CAVA earned enough trust to warrant that relative valuation? As an investor, if I could only pick one would I want own a CMG for $15M or a CAVA for $16M? Easy answer for me, personally (the former).

Another interesting point to consider is that CMG is so big and profitable that it generates a ton of free cash flow (I estimate about $1.2 billion for 2023) for management to use for stock buybacks, whereas CAVA is still burning cash because they are choosing to open new locations faster than the existing ones book profits. So at least in the near term, CMG’s share count will likely fall, while CAVA’s will likely rise - impacting future stock performance.

To get excited about investing in CAVA today I think you need to be really bullish about the concept and its ability to be successful with hundreds, if not thousands, more units across the country. Additionally, you need to feel like you are getting a low enough price that the stock’s upside potential is worth the executional risk.

My personal view is that at current prices CMG could quite possibly outperform CAVA despite it already being more than 10x larger in terms of locations opened. But even if they merely track each other, or CMG trails a bit, given the higher risk profile of a chain with fewer than 300 locations (versus one with 3,000+), I believe a risk-reward assessment still favors Chipotle. Time will tell whether that view proves prescient.

Full Disclosure: No positions in the stocks mentioned at the time of writing, but that is subject to change at any time without further notice

As of the publication date, CAVA stock was quoted at $43 with CMG at $1,860

Data sources: CMG: Q2 2023 10-Q, 2022 10-K CAVA: Q2 2023 10-Q, 2023 IPO Prospectus

Amazon Showing Further Signs of Expense Controls

About four months ago I wrote about how Amazon (AMZN) was doing lip service about operating more efficiently coming out of a time of rapid expansion during the pandemic. I figured that the stock, trading at $102 at the time, would need to see words translated into actual financial results in order to sustain a big move higher. Well, here we sit with the shares up 40% to $142 each, aided by a blowout second quarter earnings report. The early signs are good, but it will take a string of quarters in a row to convince skeptics.

I say that because although Amazon’s operating margins are running at about 5% right now, that remains below the levels seen during the 2018-2020 period (5.2%-5.9%). To truly be convinced that Amazon has permanently moved into a higher margin business model, I think they need to reach record-high margins and prove they can keep them there (and hopefully grow over time).

There are signs anecdotally as well that the company is serious about running leaner. About two years ago the company launched “Amazon Day” delivery - a feature that allowed Prime members to combine multiple orders into a single delivery on a day of their choice each week. For shipments that didn’t require 1-2 day delivery, it gave the company more flexibility with delivery speed and cost, and helped customers manage their deliveries more easily (and maybe even reduce porch pirate activity on their property).

As a loyal Amazon customer and shareholder, I loved this idea - until I tried to use it. I would frequently place multiple orders in a given week and specifically ask them all to be delivered together the following Monday. They never did. Orders placed on Tuesday, Wednesday, and Thursday would all arrive early and packaged in separate boxes. From a customer satisfaction perspective, at least get the single package part right. If you want to spend more for them to arrive earlier than expected, fine, at least non-shareholders would probably be impressed. I was so annoyed that they offered this service and then refused to honor it whenever I opted in.

But a strange thing happened yesterday. I received 5 Amazon orders - placed Sunday, Monday, and Wednesday of last week - in 1 box, on the day I requested. I have never been so happy to get an item 8 days after ordering it in my life. Coupled with the company’s second quarter earnings report, it sure seems like we can comfortably say something is going on here. Hopefully management keeps the focus on efficiency because for the stock to keep rising materially from here, I think we need to see even higher profit margins in the coming quarters (the holiday season will be very telling on that front since big volumes should make it easier to dramatically impact the bottom line). While I am cautiously optimistic on that front, paring back the stock’s weighting after a huge run makes sense too.

Full Disclosure: At the time of writing the author was long shares of AMZN (current price $142) both personally and on behalf of portfolio management clients, but positions may change at any time.

Managing Discretionary Spending When Partners Think Differently

An interesting article in the Wall Street Journal published yesterday asks “Your Credit Card Has A Spending Limit. Should Your Marriage? (paywall).” This is a fairly common question and one I have discussed numerous times with clients even though it fits more into personal finance generally than investing specifically. The author offers the suggestion that partners have an agreed upon spending limit under which any purchase need not be signed off on by the other person. For example, as long as you want to buy something for less than $500, just go ahead and both partners agree to never question it.

This solution seems like a simple way to avoid arguments about excessive spending by one particular partner in a relationship, but it has an obvious drawback that the article fails to mention; usually one partner engages in the bulk of the problematic (real or perceived) spending. A simple per-item spending cap would likely work well when both partners spend roughly equally on discretionary purchases, but the bulk of the arguments about money will occur when spending patterns diverge. If one of you buys 10 $500 items per year and the other only buys 2 such items, you might not actually avoid having an argument about excessive spending.

Is there a better solution? Every relationship is different, but I think there is a near-perfect alternative. What if each partner gets their own monthly stipend that they can spend however they want with no questions asked? As long as each person is given the same amount each month, and the total allowance fits within the family’s overall budget (and thus does not impact your long-term financial goals), this set-up can work extremely well.

My wife and I combine our finances, except for this key item. All of our income goes into a shared account but we also each have our own bank accounts that are solely funded equally by automatic monthly deposits from the shared account. No spending limits, no questions asked. And our differing spending patterns (I tend to buy fewer, more expensive items, whereas my wife is the opposite) never come into play because we are each treated equally in such an arrangement.

I call this a near-perfect solution when I recommend it to others because I can think of at least two possible criticisms. One, if each partner automatically gets their “allowance” sent over to their account each month, you can pretty much assume it will all be spent eventually, which means total spending over time might be higher than it otherwise would (this is the same argument for zero-based budgeting in the corporate world). While true, as long as the monthly amount fits nicely into your budget and doesn’t impact other goals, I think it’s okay to spend a reasonable amount on yourself.

The other potential issue comes into play if each of you has a personal credit card that is used for these purchases. In that case, one partner could actually spend more than their allowance by racking up a credit card balance and just make partial monthly payments from their own bank account. If this system is to work, you need to have enough discipline to not rack up debt individually. If both partners aren’t okay with that, then simply scrap the credit cards and rely on debit alone for personal spending.

All in all, I think this idea works great for most couples, especially when compared to alternatives such as the spending limit concept from the WSJ article, which seems to have a glaring flaw.

Will Amazon's Efficiency Push Finally Prove That E-Commerce Is A Good Business?

Last year, for the first time since I originally started to invest in Amazon (AMZN) stock back in 2014, my own sum-of-the-parts (SOTP) valuation exceeded the market price of the shares. If you are wondering why I owned it at any point when that was not the case, well, the company’s growth rate was high enough that I would not have expected it to trade below my SOTP figure - which is based solely on current financial results.

That discount got my attention, as Amazon took a drubbing in 2022 like most high-flying growth companies in the tech space coming off a wind-at-their-backs pandemic. What is most striking is just how much of Amazon’s value sits in its cloud-computing division, AWS. If one takes a moment to strip that out (everybody knows it’s insanely profitable and a complete spin-off in the future would be an enormously bullish catalyst for the stock) and focus on the e-commerce business by itself, the picture becomes a bit murky. More specifically, is that part a good business or not?

We have heard for many years - since the company’s IPO in fact - that management is focused on long-term free cash flow generation and thus does not shy away from reinvesting most/all of its profits in the near-term. But one has to wonder, at what point is “the long-term” finally upon us?

Amazon began breaking out AWS in its financial statements back in 2013, so we now have a full decade’s worth of data to judge how the e-commerce side is coming along. The verdict? Not great actually. Between 2013 and 2022, AMZN’s e-commerce operation had negative operating margins 30% of the time (2014, 2017, and 2022) and in the seven years it made money, those margins never reached 3% of sales. As you might have guessed, they peaked during 2020 at the height of the pandemic at 2.7%.

Now, do low operating margins automatically equate to a poor business? Probably not. Costco (COST), after all, has operating margins only a bit better. The difference is that Costco is a model of consistency and grows margins slowly over time, which indicates just how strong their leadership position is within retail.

For fiscal 2022, COST booked 3.4% margins, up from 2.8% in 2012. During that time they only dropped year-over year one time and even then it was only a 0.1% decline. Compare that with Amazon, which had margins of 0.1% in 2013, negative 2.4% in 2022, and year-over-year margin declines in five of the past ten years. Costco appears to be the better business.

Like many tech businesses that loaded up on employees and infrastructure during the pandemic, only to see demand wane and excess capacity sit idle, Amazon CEO Andy Jassy is focusing 2023 on operating efficiency. They are in the process of laying off extra workers and subleasing office and warehouse space they no longer need.

I think Amazon has a real opportunity to prove to investors that its e-commerce business actually is a good one that should be owned long-term in the public markets. If the company takes this efficiency push seriously, it could come out of the process with an operation that going forward is able to produce consistent profits and a growing margin profile over time with far less volatility than in the past. If that happens, I suspect the stock rallies nicely in the coming years.

If they don’t hit that level of clarity and predictability, but settle back into the old habit of ignoring near-term results and preaching the long-term narrative, I am not sure investors will have much patience. After all, Amazon has now been a public company for more than 25 years and the market wants to finally see the fruits of all that labor pay off on no uncertain terms for more than a few quarters at a time.

Full Disclosure: At the time of writing the author was long shares of AMZN (current price $102) and COST (current price $491) both personally and on behalf of portfolio management clients, but positions may change at any time.

Despite Run on SVB, Bank Deposits Appear Safer Than Long-Dated Treasuries

Given the dramatic events of the last week in regional bank land, I will share a few points that I think are interesting given where we stand right now.

1) The $250,000 insurance limit is a mirage

There is a lot of discussion about the FDIC insured deposit limit of $250,000 (whether it is high enough, should be raised, etc) but let’s be honest, the limit is meaningless. The U.S. government has repeatedly shown it is willing to take extraordinary steps to prevent cracks in the financial system from cascading into catastrophe. It only took a weekend for leadership to guarantee 100% of all deposits held with Silicon Valley Bank and Signature Bank. Thus, in this political climate, there does not seem to be any reason to worry about which bank your personal cash is held with.

2) Government-backed bonds are generally safe, but still carry risk

Despite the fact that everybody in the industry knows that long-dated bonds carry plenty of interest rate risk if you are forced to sell them before the maturity date, problems still arose here. After the Great Recession of 2008-2009, banks were encouraged to park deposits in safe securities like treasury bonds and government-backed MBS - securities that were considered safe and got you high marks during stress tests. SVB seems to have taken that to heart, in the sense that they bought lower risk stuff, but they ignored the fact that their liabilities were mostly short-term in nature and thus could very well be in position to be forced to sell them early at a loss.

The problem here was simply mismanagement - or the lack of risk management. Matching short-term deposits (VC and tech companies need to rely on short-term cash reserves much more than larger, mature, profitable businesses) with 10, 20, or even 30 year debt makes absolutely no sense. The blow could have been muted had they hedged the interest rate risk (somehow they didn’t) - or rebalanced their bond portfolio after it was clear the Fed was not slowing down the rate hikes. The fact that the yield curve was inverted during most of this period is even more shocking - as it means they were getting paid less in return for holding the riskier, longer dated bonds.

3) Contrary to the political narrative, this is definitely a bank bailout

The government announcement over the weekend was quick to highlight that any losses incurred by backstopping 100% of bank deposits at the failed institutions will be covered by the insurance fund and not the taxpayer. While true, this ignores the other part of the rescue plan. For banks that remain operational, but hold underwater positions in the same types of long dated bonds that tripped up SVB, the Fed will lend against that collateral at 100 cents on the dollar. This will minimize future bank failures by letting banks realize full value for an investment that is currently marked well below par value. Of course, this is a bank bailout using taxpayer funds (via the Fed). It may very well make a profit for the government - a la TARP - assuming they charge interest on these collateralized loans, but make no mistake - this is not private capital creating a solution but rather than Fed using its power as lender of last resort.

Much like 15 years ago, when the Fed accepted bad assets as collateral when nobody else would, SVB and Signature were the first to fail (a la Lehman and Bear) and in response those who lasted longer will reap the benefits (the other regional banks today are like Goldman and Morgan back then). So yes, it’s accurate to say the management and shareholders of failures like SVB will not get a government bailout, but their competitors will by being allowed to access newly created government-backed financial resources to keep them afloat.

4) It is likely that the Fed’s rate hiking cycle has indeed “broken something” in the economy.

But it’s not what we might have thought (the job market or GDP growth) but rather the balance sheets of the banking sector. After having been told they should hold more “good assets” like treasuries, the banks now require financial support to prevent these very securities from rendering them insolvent - even if sound risk management would have prevented problems. If this means the Fed hiking cycle will quickly come to an end, we might avoid an even bigger economic shock down the road, which could be the preferred alternative. If they keep raising rates now that banks have enhanced financial backing, well, then we’ll need to watch out for what else they will break.