Mon. Oct 18th, 2021


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Good morning. I’m sorry to let you know still think of Bed Bath & Beyond. Shares in the small U.S. household goods retailer have lost a quarter of their value since its earnings report last week, after having a fantastic run during most of the pandemic. I suspect this rather trivial stock market crash is characteristic of something bigger. An attempt to justify this eccentric view follows.

Profit margins, retail and the stock market

Here is a chart to make the bears speak:

These are operating margins on the S&P 500, thanks to the excellent Howard Silverblatt of S&P Dow Jones indices. Margins are really very high. It seems that the very supportive monetary and fiscal policies of the past year and a half have translated more or less directly into high corporate profitability.

It is natural to ask whether it could possibly be sustainable, how the average reversal could play out and what it means for the share prices. Analysts have begun to realize that earnings -bonanza (which is mainly driven by margins) may decline. Here’s an updated version of a chart I wrote about earlier here from Citi’s equity strategy team:

This is the percentage of revisions of analysts’ earnings that is rising upwards. Did it perhaps peak in August? Only consumers’ staple foods, energy and real estate have changed reviews positively. Earnings optimism is high, but ebb.

Let’s look at a microcosm, or rather an extreme case: retail stocks. Many of them made out like absolute bandits during the pandemic, and it was mostly a sideline story. Here are the operating margins of some of the winners during the 12 months immediately before Covid and beyond over the past 12 months (data from S&P Capital IQ does not include the latest quarter at Bed, Bath):

This is impressive. It is clear that a lot of prosperity has to do with consumers who are trapped in their homes and have spent a lot of money to improve their environment. But the astonishing margin expansions at Williams-Sonoma, RH and Bed Bath are not the whole story. Look at Target, Nike and Abercrombie. This is a broad phenomenon.

I spoke to Rahul Sharma of Neev Capital, a particularly keen retail analyst. He thinks what we are seeing is a combination of three factors: a fast consumer, limited available stock and the absence of discounts. Flattering conditions for a retailer. Here’s how the same stocks have performed since the start of the pandemic in February last year (I know, I know, the chart has too many lines, but keep me posted):

The performance was incredible (for context, the thick, red, dotted line is the S&P 500). However, can it hold? Here is Sharma:

Everyone thinks they have a brilliant strategic plan when things go well, but that they had no stock and that margins were large. Next year, if there is a lot of stock, and they are fighting for the consumer again, the underlying trend of the business will be visible.

We have an example of what it’s going to look like in Bed, Bath, which has given up all its performance (the heavy, pink dotted line). Stock is still tight, but it is not enough. Restrictions in the supply chain lead to higher costs rather than higher margins, now that demand has softened. Profitability collapsed during the quarter.

If Bed, Bath were the only example, none of this would matter much. The company does not have a real degree of competition and is not famous for consistently good management. But a much better positioned, very well run company, Nike, had a similar problem (thick green dotted line). When it reported in its first fiscal quarter a week or two ago, it said supply chain problems mean it was lowering its full-year full-year growth target from low double-digit to mid-single-digit growth, and that it was still expecting a gross margin expansion in compared to due to the absence of discounts, he expects less margin last year than it did earlier. Its shares have been 8% lower since the report and 15% lower than in August.

Investors do not consider supply chain issues to be transient, even for companies with strong brands and a history of execution. If a business does not make as much hay as early in the pandemic for whatever reason, its shares are hit in the face. The market seems to have come to the conclusion that businesses that have performed well, especially over the past year and a half, have not been strategic geniuses. They were happy, and it will take more than luck to negotiate over the coming months as growth slows but supply problems persist.

That said, Sharma believes some retailers have used the pandemic bonanza to invest in their businesses, and may emerge as better businesses:

I got the impression of the strong performance of some retailers who rediscovered their models — Williams-Sonoma, Dick’s Sporting Goods, Home Depot, Lowe’s, Target. People have actually connected to the brands in a more durable way. Depot and Target may stay open when all are closed, but they are not sitting on their hands. They have invested online and in people.

The conclusion, for Sharma, is not to run away from retail. But the coming months will separate wheat from chaff. Buy quality.

On the big question. Is what we see unfolding in retail an extreme example of what we can see in the broad economy and in the market? Supply chain issues that increase growth; margin stiffer; mitigating question; and sudden realization, in Warren Buffett’s phrase, about which businesses swam naked in a rising tide?

My best guess is yes, but perhaps not to the extent that the S&P margin chart above can suggest. It is worth looking at which sectors enjoyed the largest margin expansion. Again from Silverblatt:

A large part of the margin expansion was in the super-cyclical energy and materials sectors and in rate-sensitive finance and real estate. But the rest is not trivial and is probably highly concentrated in stocks and sub-sectors in particular. We need to be ready for some common regression.

Two good reading material

I was struck by the contrast between this two articles in Barron’s on investing in China. Here is the book Shehzad Qazi and Derek Scissors of China Beige, on the effects of Evergrande on the real estate industry:

Each core indicator of [the China real estate] business performance we follow, from sales revenue and profits to prices and rents, deteriorated in the third quarter. . . The deteriorating fortune of the sector has, of course, propelled real estate businesses back to fundraising. . . Evergrande’s flaws have been visible since the pandemic hit, but other property developers still see no choice but to add debt themselves. So Evergrande may not be the last round.

And here’s Justin Leverenz from Invesco:

The less-talked-about part of [Chinese] regulations focus on increasing leverage in the system and reconfiguration of growth. Part of this is increasing restrictions on property speculation. Chinese households have the second largest balance sheet in the world. It’s going to switch to stocks. . . A multi-year transformation of household asset allocation in China will drive up prices. Why should one not be a part of this explosive opportunity?

It seems to me to summarize the state of the debate.

Tobias Levkovich

Citi’s top US equity strategist has died after a car accident. We never met, but his work was excellent and I learned a lot from it. A real loss to the world community of people thinking about markets for a living.

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