Wednesday, 9 August 2017

Michael Kors +21.5%, and why value investing is so hard

Overnight (I reside in Asia), Michael Kors (KORS US) announced an above-expectation fiscal 1Q18 result, which sent the stock up 21.5% to US$45.25. Comp sales still declined by about 5-6% YoY, but this was better than the c10% decline the market was expecting. Earnings declined by about 20% YoY as operating margins fell from about 18% to 15%, but EPS declines were only in the mid single digits, because the company has bought back so many shares over the past 12 months at such low prices (the stock has been trading at 5x EBITDA and a mid-teen FCF yield for most the past 12mths).

The result placed the stock on a (pre-rally) FY18e PER of below 10x with the stock being in a net cash position at 1Q18A quarter-end of about US$150m - a multiple much too low for a highly profitable and cash generative business with a global and aspirational brand that is showing hints of possible sales and margin stabilization.

KORS was the first stock I wrote about on this blog after I launched in early February 2017. The stock was trading at about US$40 at the time. The thesis was simple: the stock was extremely cheap and priced for perpetual structural decline, whereas in reality it was not yet clear if the declines were structural or cyclical in nature. Furthermore, I reasoned that while I had no idea if and when sales would stabilize, neither did anyone else, and that was all I needed to know, because the market tends to systematically underpriced these types of stocks. If one takes a basketed/diversified approach, which I did with KORS, the eventual outcome is not altogether important - only the return expectancy at the time of purchase.

The lack of visibility on the outlook for sales was the reason the stock was cheap and no one was prepared to buy it. It is hard to pitch a stock to a client or your PM boss when you can't answer the questions "so when do sales bottom?"; "what evidence do we have that sales will turn around and when?"; and "what is the catalyst?". "I don't know but neither does anybody else and the stock is cheap" is usually not considered a satisfactory answer.* I reasoned that the stock was likely to rally significantly on the first sign sales declines were slowing, because that would provide investors with the comfort they needed to buy what is an obviously cheap stock. That is exactly what occurred yesterday.

However, within a few days of me outlining this simplified long thesis in February, the stock cratered to as low as US$35 after the company fiscal 3Q17 disappointed, although it quickly rebounded to US$37-38. I added more in the low US$35s and wrote about how this was a seemingly inauspicious start to the blog. In the subsequent six months, the stock remained weak, and temporarily fell to as low cUS$32 in May after the company reported another soft 4Q17 result, although it quickly rebounded to US$35. I continued buying stock all the way down to US$32.51, increasing my position size to about a 60bp portfolio weight at an average cost of about US$37.

I am now up more than 20% on the position with an average time-weighted holding period (as I bought in stages) of about 4mths - an attractive return, particularly because I believe it was delivered with below-average level of market/valuation risk. However, what is intriguing is that my call on KORS has looked wrong every single day for the past six months. Furthermore, I have had to endure six months of continuous negative reinforcement. And yet I was right and did exactly the right thing.

This says a lot about why value investing is so hard for many people, and also about why it is so profitable. It is hard to risk looking wrong continuously to one's clients and/or bosses for months or even years on end, particularly when one buys a stock where the problems, challenges, and risks facing the company are so obviously apparent to all. Furthermore, the continuous negative reinforcement day after day, as the share price remains weak/declining, and all the broker/market news commentary on the stock remains incessantly negative, is too psychologically painful for most investors to bear (for some reason I appear congenitally immune from this). The result is that such stocks gets shunned, which is exactly why the risk/reward characteristics for these sorts of stocks are unusually attractive.

Because negative future outcomes are already assumed and expected by investors, and hence factored into the price, the stocks tend to be relatively resilient in the face of bad news. As David Dreman noted in has masterful book Contrarian Investment Strategy, negative news tends to be viewed as a 'confirmatory event', confirming the market's original assessment. However, any favourable (or even less bad) developments are a surprise that act to change opinions, and when that happens to a previously neglected stock, the upside move can be violent and sudden (the reverse, by the way, is true for expensive market favourates).

The bottom line is this: Almost all of the big excess returns in markets are in the tails and driven by surprises that result in changes of opinion; consequently, what you should be looking for in markets is not stocks with favorable outlooks and good businesses per se (these attributes are generally already known to the market and reflected in prices), but rather the capacity for favourable change/surprise. It is a counter-intuitive process, because it requires you bet on things occurring that you cannot currently envisage and/or do not necessarily expect to occur. That is hard for many people to do.

It feels safer to a lot of investors to buy KORS now. It appears that sales may be beginning to stablise. But the truth is it is now a lot more risky, because the stock is now 20% more expensive and the outlook is in actuality no less uncertain than it was. It merely feels less risky to investors because they have a seemingly irresistible urge to extrapolate recent experience rather than think in terms of probability and non-linearity/cyclical change.

I am not overly enthused about the company's recent Jimmy Choo acquisition at 18x EBITDA either (I feel the company's capital would have been better deployed into continuing share buy-backs). The acquisition is nevertheless being financed by low-cost debt (4.25-4.75%) rather than equity, which the company can comfortably afford to take on board given its strong balance sheet and robust cash flows.

I think the stock is probably worth about US$55/share, or 15x its current earnings run-rate, struck on 15% core EBIT margins. There is a wide bell curve of potential fair valuations around this possible mean though - it could be a lot higher if the company returns to positive sales and earnings growth (favoured luxury goods companies with positive sales and earnings deltas often trade at PE multiples in the 20s and 2-3x EV/sales multiples), but there are continuing downside risks as well. I plan to hold my existing position (about 70bp post-rally) for now but will be looking to trim on any continuing strength rather than add.


*Even David Einhorn sold his KORS position because (paraphrasing) his 'thesis about sales rebounding did not eventuate'. This is a serious problem with Einhorn's 'no broken thesis' rule. It requires a tangible catalyst and pays no heed to valuation when selling in response to that catalyst not playing out. I like Einhorn, but this is fundamentally the wrong approach in my opinion.

The above analysis is furnished for informational/entertainment purposes only, and is not to be construed as investment advice. The author provides no warranty whatsoever as to the accuracy of the contents of the post, and reserves all rights to trade in any securities mentioned in any article at any time. 

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