Fisher Investments on Consumer Discretionary [1 ed.] 047052703X, 9780470527030

Table of contents :
Fisher Investments on Consumer Discretionary
Contents
Foreword
Preface
USING YOUR CONSUMER DISCRETIONARY GUIDE
Acknowledgments
Part I: GETTING STARTED IN CONSUMER DISCRETIONARY
Chapter 1: CONSUMER DISCRETIONARY BASICS
CONSUMER DISCRETIONARY 101
GETTING TO KNOW THE CONSUMER DISCRETIONARY SECTOR
Chapter 2: THE HISTORY OF THE CONSUMER DISCRETIONARY SECTOR
THE EARLIEST AMERICAN CONSUMERS
THE BIRTH OF THE MODERN CONSUMER DISCRETIONARY SECTOR
Chapter 3: CONSUMER DISCRETIONARY SECTOR DRIVERS
ECONOMIC DRIVERS
POLITICAL DRIVERS
SENTIMENT DRIVERS
Part II: NEXT STEPS: CONSUMER DISCRETIONARY DETAILS
Chapter 4: CONSUMER DISCRETIONARY SECTOR LANDSCAPE
GLOBAL INDUSTRY CLASSIFICATION STANDARD (GICS)
GLOBAL CONSUMER DISCRETIONARY BENCHMARKS
AUTOMOBILES & COMPONENTS INDUSTRY GROUP
RETAILING INDUSTRY GROUP
MEDIA INDUSTRY GROUP
CONSUMER DURABLES & APPAREL INDUSTRY GROUP
CONSUMER SERVICES INDUSTRY GROUP
Chapter 5: CHALLENGES IN THE CONSUMER DISCRETIONARY SECTOR
CHALLENGE 1: GROWING PROFITS IN MATURE MARKETS
CHALLENGE 2: MANAGING VOLATILE DEMAND
CASE STUDY: CALLAWAY GOLF
Chapter 6: HOUSEHOLD DEBT—MYTHS AND OPPORTUNITIES
HOUSEHOLD DEBT IN DEVELOPED MARKETS—BASICALLY A VERY USEFUL TOOL
TREMENDOUS OPPORTUNITIES IN EMERGING MARKETS
CASE STUDY: BRAZIL’S CREDIT-DRIVEN CONSUMPTION BOOM
Part III: THINKING LIKE A PORTFOLIO MANAGER
Chapter 7: THE TOP-DOWN METHOD
INVESTING IS A SCIENCE
EINSTEIN’S BRAIN AND THE STOCK MARKET
THE TOP-DOWN METHOD
TOP DOWN DECONSTRUCTED
MANAGING AGAINST A CONSUMER DISCRETIONARY BENCHMARK
Chapter 8: SECURITY ANALYSIS
MAKE YOUR SELECTION
A FIVE-STEP PROCESS
IMPORTANT QUESTIONS TO ASK
Chapter 9: CONSUMER DISCRETIONARY INVESTMENT STRATEGIES
STRATEGY 1: ADDING VALUE AT THE INDUSTRY AND SUB-INDUSTRY LEVEL
STRATEGY 2: ADDING VALUE AT THE SECURITY LEVEL
STRATEGY 3: ADDING VALUE IN A CONSUMER DISCRETIONARY SECTOR DOWNTURN
HOW TO IMPLEMENT YOUR STRATEGY
Notes
About the Authors
Index

Citation preview

(continued from front flap)

$49.95 USA / $59.95 CAN

Filled with in-depth insights and expert advice, Fisher Investments on Consumer Discretionary provides

T

a framework for understanding this sector and its industries to help you make better investment decisions—now and in the future. With this book as

on CONSUMER DISCRETIONARY

understand and analyze investment opportunities—

Consumer Discretionary sector and discover strategies

This installment of the Fisher Investments On series is a comprehensive guide to the Consumer

to help achieve your investing goals.

Discretionary industry—which includes companies such as auto manufacturers, homebuilders,

on

CONSUMER DISCRETIONARY

sports equipment manufacturers, hotel developers and operators, cruise lines, retail websites, and department stores, to name just a few.

Analyst at Fisher Investments. Renaud graduated from Santa Clara University with a bachelor’s degree in finance. Hailing from Minnetonka, Minnesota, he currently resides in San Francisco, California.

ANDREW S. TEUFEL has been with Fisher Investments since 1995, where he currently serves as

Stearns as a corporate finance analyst in its Global Technology Group. Teufel also instructs at many seminars and educational workshops throughout the United States and United Kingdom, and has lectured

Consumer Discretionary sector. It shows how to determine better times to invest in Consumer Discretionary, which Consumer Discretionary industries and sub-industries are likelier to do best, and how individual stocks can benefit in various environments. The global Consumer Discretionary sector is complex, covering many sub-industries and countries with unique

or other components of the global stock market. While this guide specifically focuses on Consumer Discretionary, the basic investment methodology is applicable for analyzing any global sector, regardless of the current macroeconomic environment.

Following a top-down approach to investing, Fisher Investments on Consumer Discretionary can help

to identify their differences, spot opportunities, and avoid major pitfalls.

Consumer Discretionary sector. It skillfully addresses how to determine the optimal times to invest in

Given the vast market landscape and diverse geographic operations, it is vital to maintain a global perspective when investing in the Consumer Discretionary sector. This invaluable resource provides the tools that can help you understand and analyze opportunities both in the United States and abroad within this diverse sector. For more information, visit www.consumerdiscretionary.fisherinvestments.com.

About Fisher Investments Press

is a graduate of UC Berkeley. Fisher Investments Press brings the research, analysis, and market intelligence of Fisher Investments’ research team, headed by CEO and New York Times bestselling author Ken Fisher, to all investors. The Press covers a range of investing and market-related topics for a wide Jacket Design: Leila Amiri Jacket Images: © iStockphoto

easily accessible primer to economic sectors, regions,

you make more informed decisions within the

at the Haas School of Business at UC Berkeley. He is also the Editor in Chief of MarketMinder.com. Teufel

primarily for investing in global stocks. Each guide is an

characteristics. Using the framework detailed in this book, you can learn to be better equipped

audience—from novices to enthusiasts to professionals.

CONSUMER DISCRETIONARY

to joining Fisher Investments, he worked at Bear

This reliable guide can help you in making top-down investment decisions specifically for the

Consumer Discretionary stocks and which Consumer

on

a Co-President and the Director of Research. Prior

provide individual investors, aspiring investment

professionals, and students the tools necessary to

your guide, you can gain a global perspective of the

ERIK RENAUD is a Consumer Discretionary Research

he Fisher Investments On series is designed to

Discretionary industries and sub-industries have the potential to perform well in various environments.

Divided into three comprehensive parts—Getting Started, Consumer Discretionary Details, and

• An in-depth look at the global Consumer Discretionary universe, including automobiles, consumer durables and services, retailing, and media

• Tips and tools for security analysis and portfolio management

• A useful guide for investing in any market condition

Thinking Like a Portfolio Manager—Fisher Investments on Consumer Discretionary: • Explains some of the sector’s key macro drivers—like consumer spending, income, and employment • Shows how to capitalize on a wide array of macro conditions and industry-specific features to help you form an opinion on each of the industries within the sector • Takes you through the major components of the 12 subindustries within the global Consumer Discretionary sector and reveals how they operate • Offers investment strategies to help you determine when and how to overweight specific industries within the sector • Outlines a five-step process to help differentiate firms in this field—designed to help you identify ones with the greatest probability of outperforming

Foreword by New York Times bestselling author Ken Fisher

ISBN: 978-0-470-52703-0

(continued on back flap)

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Fisher Investments on Consumer Discretionary

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FISHER INVESTMENTS PRESS Fisher Investments Press brings the research, analysis, and market intelligence of Fisher Investments’ research team, headed by CEO and New York Times best-selling author Ken Fisher, to all investors. The Press covers a range of investing and market-related topics for a wide audience—from novices to enthusiasts to professionals. Books by Ken Fisher How to Smell a Rat The Ten Roads to Riches The Only Three Questions That Count 100 Minds That Made the Market The Wall Street Waltz Super Stocks Fisher Investments Series Own the World by Aaron Anderson 20/20 Money by Michael Hanson Fisher Investments On Series Fisher Investments on Energy Fisher Investments on Materials Fisher Investments on Consumer Staples Fisher Investments on Industrials Fisher Investments on Emerging Markets Fisher Investments on Technology Fisher Investments on Consumer Discretionary

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Fisher Investments on Consumer Discretionary

Fisher Investments with Erik Renaud and Andrew Teufel

John Wiley & Sons, Inc.

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Copyright © 2010 by Fisher Investments Press. All rights reserved. Published by John Wiley & Sons, Inc., Hoboken, New Jersey. Published simultaneously in Canada. No part of this publication may be reproduced, stored in a retrieval system, or transmitted in any form or by any means, electronic, mechanical, photocopying, recording, scanning, or otherwise, except as permitted under Section 107 or 108 of the 1976 United States Copyright Act, without either the prior written permission of the Publisher, or authorization through payment of the appropriate per-copy fee to the Copyright Clearance Center, Inc., 222 Rosewood Drive, Danvers, MA 01923, (978) 750-8400, fax (978) 646-8600, or on the web at www.copyright.com. Requests to the Publisher for permission should be addressed to the Permissions Department, John Wiley & Sons, Inc., 111 River Street, Hoboken, NJ 07030, (201) 748-6011, fax (201) 748-6008, or online at http://www.wiley.com/go/permissions. Important Disclaimers: This book reflects personal opinions, viewpoints and analyses of the author and should not be regarded as a description of advisory services provided by Fisher Investments or performance returns of any Fisher Investments client. Fisher Investments manages its clients’ accounts using a variety of investment techniques and strategies not necessarily discussed in this book. Nothing in this book constitutes investment advice or any recommendation with respect to a particular country, sector, industry, security or portfolio of securities. All information is impersonal and not tailored to the circumstances or investment needs of any specific person. Limit of Liability/Disclaimer of Warranty: While the publisher and author have used their best efforts in preparing this book, they make no representations or warranties with respect to the accuracy or completeness of the contents of this book and specifically disclaim any implied warranties of merchantability or fitness for a particular purpose. No warranty may be created or extended by sales representatives or written sales materials. The advice and strategies contained herein may not be suitable for your situation. You should consult with a professional where appropriate. Neither the publisher nor author shall be liable for any loss of profit or any other commercial damages, including but not limited to special, incidental, consequential, or other damages. For general information on our other products and services or for technical support, please contact our Customer Care Department within the United States at (800) 762-2974, outside the United States at (317) 572-3993 or fax (317) 572-4002. Wiley also publishes its books in a variety of electronic formats. Some content that appears in print may not be available in electronic books. For more information about Wiley products, visit our web site at www.wiley.com. ISBN 978-0-470-52703-0 Printed in the United States of America 10 9 8 7 6 5 4 3 2 1

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Contents

Foreword

ix

Preface

xi

Acknowledgments

xv

Part I Getting Started in Consumer Discretionary

1

Chapter 1 Consumer Discretionary Basics

3

Consumer Discretionary 101 Getting to Know the Consumer Discretionary Sector Chapter 2 The History of the Consumer Discretionary Sector

4 13

19

The Earliest American Consumers

20

The Birth of the Modern Consumer Discretionary Sector

23

Chapter 3 Consumer Discretionary Sector Drivers

35

Economic Drivers

36

Political Drivers

49

Sentiment Drivers

54

v

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vi

Contents

Part II Next Steps: Consumer Discretionary Details

57

Chapter 4 Consumer Discretionary Sector Landscape

59

Global Industry Classification Standard (GICS)

60

Global Consumer Discretionary Benchmarks

61

Automobiles & Components Industry Group

66

Retailing Industry Group

72

Media Industry Group

76

Consumer Durables & Apparel Industry Group

81

Consumer Services Industry Group

86

Chapter 5 Challenges in the Consumer Discretionary Sector Challenge 1: Growing Profits in Mature Markets

91 91

Challenge 2: Managing Volatile Demand

101

Case Study: Callaway Golf

106

Chapter 6 Household Debt—Myths and Opportunities

111

Household Debt in Developed Markets—Basically a Very Useful Tool

112

Tremendous Opportunities in Emerging Markets

117

Case Study: Brazil’s Credit-Driven Consumption Boom

118

Part III Thinking Like a Portfolio Manager

127

Chapter 7 The Top-Down Method

129

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Investing Is a Science

130

Einstein’s Brain and the Stock Market

131

The Top-Down Method

132

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Contents

vii

Top Down Deconstructed

138

Managing Against a Consumer Discretionary Benchmark

145

Chapter 8 Security Analysis

151

Make Your Selection

152

A Five-Step Process

153

Important Questions to Ask

161

Chapter 9 Consumer Discretionary Investment Strategies

167

Strategy 1: Adding Value at the Industry and Sub-Industry Level

168

Strategy 2: Adding Value at the Security Level

174

Strategy 3: Adding Value in a Consumer Discretionary Sector Downturn

174

How to Implement Your Strategy

176

Notes

179

About the Authors

183

Index

185

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Foreword

Y

ou’re holding the seventh in a series of investing guides from Fisher Investments Press—the first ever imprint from a money manager— produced in partnership with John Wiley & Sons. These guides are your introduction to a usable, top-down strategy for analyzing standard investing sectors (Energy, Materials, Consumer Staples, Health Care, Industrials, etc.) as well as other investing regions and categories. They are meant to stand alone—each an in-depth introduction to a category sparking your interest. Or, read together, they are a do-it-yourself training regimen for the full breadth of capital markets analysis. This guide is on Consumer Discretionary—currently about 9 percent of total world stocks (as measured by the MSCI All Country Index). Discretionary may bring to mind luxury goods, cars, restaurants, and fancy vacations. And it’s that, but the sector is far more diverse. It’s also clothing and the firms making and distributing textiles. It’s auto parts, but also power tools, building materials, and even some heavy manufacturing. The major defining characteristic is these are goods and services you typically want. Contrast that with Consumer Staples firms, which make the things you need—though it’s not always and everywhere like that, and the book shows you how to know. Overall, consumer spending is much more stable than most think, but Discretionary spending will be more volatile than Staples spending. Hence, Consumer Discretionary tends to be more economically sensitive, while Consumer Staples is seen as more defensive. But it’s never as easy as just timing economic cycles—though that itself isn’t easy. First, the sector is too broad, and some areas are more economically sensitive than others. To invest successfully here, you ix

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Foreword

must know what distinct drivers impact each of Discretionary sector’s diverse industries and sub-industries—the book shows you. And you must remember that stocks look forward, not back, so it’s perfectly normal for Discretionary stocks to start zooming when the world looks bleak and you can’t imagine why folks would spend on cruises, cars, and jewelry. And it’s wrong to think Consumer Discretionary is inherently riskier just because it’s overall more economically sensitive than Consumer Staples or any other sector. Or that Discretionary should get better or worse returns. Given enough time, finance theory says all equity categories should net similar returns when properly accounted for—though traveling drastically different paths over the short to intermediateterm. Ultimately, given enough time, newly created supply or the destruction of existing supply (which is simply little more than investment bankers creating paper or destroying paper) tends to equalize categories. In the nearer term, demand tends to drive stock prices, but longer term (what may seem for most like an eternity but really isn’t) supply swamps demand for that category. That’s why a good portfolio is broadly diversified and why this book (and the entire series) can help you learn to be a better investor. What the book won’t give you is hot stock tips for 2010, 2011, 2018, or 2035. Such a thing doesn’t exist—someone telling you otherwise is selling you something that’s probably bad for you. Rather, this book provides a workable, repeatable framework for increasing the likelihood of finding profitable opportunities in the Consumer Discretionary sector. And the good news is the investing methodology presented here works for all investing sectors and the broader market. This methodology should serve you not only this year or next, but the whole of your investing career. So good luck and enjoy the journey. Ken Fisher CEO of Fisher Investments Forbes Portfolio Strategy columnist Author of the New York Times Best Sellers The Ten Roads to Riches and The Only Three Questions That Count

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Preface

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he Fisher Investments On series is designed to provide individual investors, students, and aspiring investment professionals the tools necessary to understand and analyze investment opportunities, primarily for investing in global stocks. Within the framework of a “top-down” investment method (more on that in Chapter 7), each guide is an easily accessible primer to economic sectors, regions, or other components of the global stock market. While this guide is specifically on Consumer Discretionary, the basic investment methodology is applicable for analyzing any global sector, regardless of the current macroeconomic environment. Why a top-down method? Vast evidence shows high-level, or “macro,” investment decisions are ultimately more important portfolio performance drivers than individual stocks. In other words, before picking stocks, investors can benefit greatly by first deciding if stocks are the best investment relative to other assets (like bonds or cash), and then choosing categories of stocks most likely to perform best on a forward-looking basis. For example, a Technology sector stock picker in 1998 and 1999 probably saw his picks soar as investors cheered the so-called “New Economy.” However, from 2000 to 2002, he probably lost his shirt. Was he just smarter in 1998 and 1999? Did his analysis turn bad somehow? Unlikely. What mattered most was stocks in general, and especially US Technology stocks, did great in the late 1990s and poorly entering the new century. In other words, a top-down perspective on the broader economy was key to navigating markets—stock picking just wasn’t as important. Fisher Investments on Consumer Discretionary can help guide you in making top-down investment decisions specifically for the Consumer xi

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Preface

Discretionary sector. It shows how to determine better times to invest in Consumer Discretionary, what Consumer Discretionary industries and sub-industries are likelier to do best, and how individual stocks can benefit in various environments. The global Consumer Discretionary sector is complex, covering many sub-industries and countries with unique characteristics. Using our framework, you can be better equipped to identify their differences, spot opportunities, and avoid major pitfalls. This book takes a global approach to Consumer Discretionary investing. Most US investors typically invest the majority of their assets in domestic securities; they forget America is less than half of the world stock market by weight—over 50 percent of investment opportunities are outside our borders. However, because the US is the world’s biggest consumer market and is home to the largest share of Consumer Discretionary stocks in the world, this guide may feel more US-centric than the others in the Fisher Investments On series. Still, Consumer Discretionary companies may have global operations, and consumer markets outside the US are growing rapidly. Given the vast market landscape and diverse geographic operations, it’s vital to have a global perspective when investing in the Consumer Discretionary sector. USING YOUR CONSUMER DISCRETIONARY GUIDE This guide is designed in three parts. Part I, “Getting Started in Consumer Discretionary,” discusses vital sector basics and Consumer Discretionary sector high-level drivers. Here we’ll discuss macro drivers— consumer spending, income, and employment—and explain how to capitalize on a wide array of macro conditions and industry-specific features to help you form an opinion on each of the industries within the sector. We’ll also discuss additional drivers affecting the sector that ultimately drive Consumer Discretionary stock prices. Part I also includes a discussion on the history of the modern Consumer Discretionary sector. Topics discussed include early trade relations in the colonies and how the industrial revolution contributed

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xiii

to a dramatic increase in discretionary income, in turn creating the Consumer Discretionary industries we’re familiar with today. Part II, “Next Steps: Consumer Discretionary Details,” walks through the next step of sector analysis. We’ll take you through the global Consumer Discretionary sector investment universe and its diverse components. The Consumer Discretionary sector is fairly diverse, which makes a thorough analysis challenging but also increases your chances of finding successful investment opportunities and profitable segments of the market. There are currently 12 industries within the Consumer Discretionary sector. We will take you through the major components of the sector in detail, including a description of their business and industry, an introduction to how they operate, and what drives profitability—to give you the tools to determine which industry will most likely outperform or underperform looking forward. Part II concludes with a discussion about the tremendous opportunity credit represents in Emerging Markets against the backdrop of Brazil’s successful financial liberalization. Part III, “Thinking Like a Portfolio Manager,” delves into a topdown investment methodology and individual security analysis. You’ll learn to ask important questions like: What are the most important elements to consider when analyzing retail or automotive firms? What are the greatest risks and red flags? This book gives you a five-step process to help differentiate firms so you can identify ones with a greater probability of outperforming. We’ll also discuss a few investment strategies to help determine when and how to overweight specific industries within the sector. Note: We’ve specifically kept the strategies presented here high level so you can return to the book for guidance no matter the market conditions. But we also can’t possibly address every market scenario and how markets may change over time. Many additional considerations should also be taken into account when crafting a portfolio strategy, including your own investing goals, your time horizon, and other factors unique to you. Therefore, you shouldn’t rely solely on the strategies and pointers addressed here—they won’t always apply. Rather, this book

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is intended to provide general guidance and help you begin thinking critically not only about the Consumer Discretionary sector, but about investing in general. Further, Fisher Investments on Consumer Discretionary won’t give you a “silver bullet” for picking the right Consumer Discretionary stocks. The fact is the “right” Consumer Discretionary stocks will be different in different times and situations. Instead, this guide provides a framework for understanding the sector and its industries so that you can be dynamic and find information the market hasn’t yet priced in. There won’t be any stock recommendations, target prices, or even a suggestion whether now is a good time to be invested in the Consumer Discretionary sector. The goal is to provide you with tools to make these decisions for yourself, now and in the future. Ultimately, our aim is to give you the framework for repeated, successful investing. Enjoy.

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Acknowledgments

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o book is ever the product of just one or two people, and we extend our sincere gratitude to a number of colleagues and business associates for their help in making this book a reality. First, we thank Ken Fisher for opening the door to this wonderful opportunity. Also, we thank Jeff Silk for constantly encouraging us to challenge our convictions. There are also a number of Fisher Investments colleagues instrumental to this project, each deserving our praise and thanks. Second, we owe special thanks to Lara Hoffmans and Michael Hanson, whose patient mentoring and editing were integral in bringing this book from the idea stage to completion. Evelyn Chea deserves healthy praise for offering much appreciated assistance with source citations and other tactical manuscript details—including some expert copy editing. Leila Amiri brought valuable graphic design contributions in coming up with the graphics that appear in the book and on its cover. Much thanks to Camille Zahniser, Dan Sinton and John Hulwick for their flexibility and help in carrying out Erik’s full-time research responsibilities while he was working on the book. Writing this book would never have gone so smoothly without the guidance and advice of previous Fisher Investments Press authors, namely Michael Cannivet, Aaron Azelton, Brad Pyles, Matt Schrader, Brendan Erne, and Austin Fraser. Special thanks also go to the team that brought Fisher Investments Press to life—Marc Haberman, Molly Lienesch, and Fabrizio Ornani. Of course this book would also not be possible without our data vendors, so we owe a debt of gratitude to Thomson Reuters and Global Financial Data in particular for their permissions. We’d also xv

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xvi

Acknowledgments

like to extend our appreciation to our team at Wiley for their support and guidance throughout this project, especially Laura Walsh and Kelly O’Connor. Last, Erik would like to thank his family, particularly Erik Renaud Sr., Jennifer Renaud, Lucille Renaud-Ruiz, Gerardo Ruiz, and Danielle Renaud for their love and support.

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I GETTING STARTED IN CONSUMER DISCRETIONARY

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1 CONSUMER DISCRETIONARY BASICS

W

hether you’re a blue-blooded socialite or a blue-collared mechanic, the Consumer Discretionary sector plays a material role in your everyday life. How? Consumer Discretionary may conjure images of high-end jewelry, luxury cruises, mega-big-ticket electronic goodies, and other high-priced glamour items—and those items do fall within the sector, but it is much broader than that. For example, just the process of buying and enjoying this book likely involved a number of goods and services from Consumer Discretionary firms. Odds are, you purchased this book from a bookstore (a Specialty Retail firm). Perhaps you drove your car (produced by the Automobile industry) to that bookstore and stopped for a coffee (Hotels, Restaurants, & Leisure firm) on the way to or from. Maybe you’re reading this from the comfort of a recliner or on the screen of a new handheld device (both built by a Household Durables firm). The book itself was published by John Wiley & Sons (a Media firm). These are just a few industries included in the Consumer Discretionary sector. Although these categories represent the sector from a high level, it is important to reiterate this segment’s breadth. Auto manufacturers, 3

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4

Fisher Investments on Consumer Discretionary

homebuilders, sports equipment manufacturers, hotel developers and operators, advertising agencies, newspaper publishers, cruise lines, car dealerships, retail websites, department stores, and beauty salons are all examples of Consumer Discretionary firms. In other words, it’s more diverse than you might think. This chapter introduces you to the Consumer Discretionary sector and its five industry groups. You should finish the chapter with a high-level understanding of the sector, how to identify its components, and what exactly makes a firm Consumer Discretionary. CONSUMER DISCRETIONARY 101 Globally, the Consumer Discretionary sector makes up about 8.8 percent of world stocks—just a bit smaller than the Staples sector (see Table 1.1). This amount isn’t static. All sectors change in relative size as they come in and out of favor and the stocks get bid up or down. It’s not a massive sector, but the variety of firms included is immense. One might ask, “What do newspapers and cruise lines have in common? Why are they in the same sector?” Or perhaps, “What about cigarettes or beer? Those are discretionary goods, right?” Or even, “What’s the

Table 1.1 MSCI ACWI Sector Weights Sector

Weight (%)

Financials

20.2

Energy

12.0

Information Technology

11.8

Industrials

9.9

Consumer Staples

9.8

Health Care

9.7

Consumer Discretionary

8.8

Materials

7.6

Telecommunication Services

5.3

Utilities

4.9

Source: Thomson Reuters, as of 6/30/2009.

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Consumer Discretionary Basics

5

Elastic versus Inelastic Frequently in this book, we’ll refer to a product being elastic or inelastic, or that demand is elastic or inelastic. So what does that mean? It means a lot like it sounds. Elastic demand stretches and snaps back, whereas inelastic demand stays constant. This is the core of the difference between Discretionary and Staples firms. When times are flush, the economy is growing, incomes are rising, and people are more likely to buy bigger ticket items, take pricier vacations, eat out at restaurants, etc. That benefits Consumer Discretionary firms’ bottom lines and usually translates into rising stock prices too. But when the economy slows or goes into recession, demand for those things snaps back, usually hurting Discretionary firms’ earnings and stock prices. On the flip side, demand for Consumer Staples goods is usually inelastic. Whether times are good or bad, people still need to brush their teeth and buy basic foodstuffs. If the economy is raging, people don’t buy more toothpaste. And if the economy falls, they typically also don’t spend less (or at least, not much less) on these items. Demand is stable—inelastic. Sectors that are more inelastic are sometimes also called defensive because they usually perform better on a relative basis during bear markets or when the broad market is overall sluggish.

difference between Consumer Staples and Consumer Discretionary?” To answer these questions, let’s begin with some definitions. Misleading Names

The first word, “Consumer,” is simple—if you have ever purchased something, you are a consumer. (Note this definition does not typically include purchases made by businesses.) Put another way, if a good is made for “final” use by someone, it’s a consumer good. Goods made for businesses are often called “capital” or “enterprise” goods because they’re used in the process of creating something else. The second piece, “Discretionary,” if taken as the dictionary definition, refers to something done based on one’s prerogative (i.e., needs versus wants). Basic food, shelter, and clothing are most frequently associated with necessities, while most everything else can be classified as a want, or discretionary. Using this definition, restaurants (food),

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6

Fisher Investments on Consumer Discretionary

homebuilders (shelter), and apparel manufacturers (clothing) might seem better categorized as Staples, as these are all necessities, not discretionary items. Similarly, cigarettes and alcohol would be considered Discretionary, since they are clearly not necessities. Except, seemingly illogically (at least at first) restaurants, homebuilders, and apparel manufacturers are included in the Consumer Discretionary sector, while tobacco and spirits producers are Staples (see Fisher Investments on Consumer Staples for more information). So, to understand how to identify a Consumer Discretionary firm, it’s better to define the group using common characteristics. Typically, firms in the Consumer Discretionary sector are: • Economically sensitive • Highly correlated to broad stock market performance • Sensitive to consumer sentiment

Correlations and R-Squared Few of us voluntarily hearken back to Statistics 101, but this book relies heavily on the use of correlations and correlation coefficients (R-Squared) to gauge the strength of certain relationships. We’ll skip the heavy math and keep it simple with some qualitative explanations of what these measures describe. A correlation tracks directional relationships between two or more variables and falls between 1.0 and –1.0. A correlation very close to 1.0 means two things are strongly positively correlated—they move in the same direction at the same time and in about the same amount. A correlation close to –1.0 means two things are strongly negatively correlated—one’s up when the other’s down. A correlation close to 0 means there’s no relation—their movements are entirely independent and there’s no clear pattern. But be careful! Correlations do not imply causation; they simply tell us about their movements. Things can be correlated all the time—doesn’t mean the one causes the other’s movements. When you discover a strong correlation—positive or negative—ask whether the relationship makes sense and try to find a fundamental reason for the link. Many correlations are merely coincidental, not causal.

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The correlation coefficient, or R-Squared, is another useful measurement, telling you how much of the change in one variable can be explained by changes in the other. It’s simply the correlation, squared. The number ranges from 0 to 1.0— the closer to 1.0 the stronger the relationship. As a rule of thumb, if the correlation coefficient is above 0.5 (half of the movement in the dependent variable can be explained by movements in the independent variable), there is a fairly healthy relationship.

Economically Sensitive

A healthy, growing economy is vital to the Consumer Discretionary sector. Personal consumption expenditures (PCE; also known as consumer spending) are a key demand driver for Consumer Discretionary stocks and make up approximately 70 percent of gross domestic product (GDP)1—which will be covered more in Chapter 3. Keep in mind, not all that spending goes toward goods and services produced by Consumer Discretionary firms. A major chunk of total spending—about 66 percent as of 2009—goes toward services, which includes things like health care, financial services, etc. Another big chunk goes toward non-discretionary items typically found in the Consumer Staples sector. Only about 12 percent of spending is attributed to durable goods, which most directly impact Consumer Discretionary firms (though there’s some overlap in spending, covered more in depth in Chapter 3). So while a major portion of global GDP is attributed to consumer spending, the goal of a Consumer Discretionary analyst is to understand what impacts the portion most important to Consumer Discretionary stocks. Still, most Consumer Discretionary firms benefit from an overall strong spending environment. For example, when personal income and spending are strong or growing, consumers generally eat at restaurants more frequently—which fall in the Discretionary sector. However, they won’t necessarily purchase an extra loaf of bread at the supermarket (a Staples firm). This is why restaurants are included in the Discretionary sector and grocery stores are not.

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Beeronomics When the economy is weakening and unemployment is rising, what happens to alcohol sales? A common myth during periods of economic weakness suggests consumers— supposedly depressed by job losses and a dour economic outlook—turn to booze as a way to self-medicate. This seems plausible—not many would argue with enjoying a few potent potables after hitting a particularly rough patch. But if this were true, we’d see a meaningful, negative correlation between alcohol sales and economic growth. In other words, when the economy falls, alcohol sales would rise. Unfortunately for believers of this myth, alcohol sales and economic growth show no material connection (see Figure 1.1). 6.0%

10.0%

4.0%

8.0%

3.0%

6.0%

2.0%

4.0%

1.0%

2.0%

0.0%

0.0% ⫺2.0%

⫺1.0% 2008

2007

2006

2005

2004

2003

2002

2001

2000

1999

1998

1997

1996

1995

⫺2.0%

Correlation: 12%

US Retail Sales of Beer, Wine, and Liquor

5.0%

Gross Domestic Product

12.0%

Year-Over-Year Changes in US Retail Sales of Beer, Wine, and Liquor Year-Over-Year Changes in Gross Domestic Product

⫺4.0%

Figure 1.1 GDP and US Retail Sales of Beer, Wine, and Liquor Stores Source: Thomson Reuters.

A Nielsen survey in May 2008 showed 80 percent of respondents indicated they had no intentions of changing their drinking habits in response to the weakening economy. Put simply, booze is a relatively cheap indulgence, and the economy, whether growing or shrinking, has minimal impact on consumption. Remember, in the Consumer Discretionary sector, demand is usually leveraged to economic growth. Since there’s no meaningful relationship, alcohol isn’t a good fit for the Discretionary sector. Source: Christopher Farrell, “Economic Trends,” BusinessWeek (November 12, 2001), accessed on December 11, 2009; “Declining Economy Has Little Impact on Consumers’ Alcoholic Beverage Purchases in Stores,” Nielsen (June 3, 2008), accessed on December 11, 2009; Adam Geller, “During Downturn, People Find Money for Booze,” Associated Press (September 7, 2008), accessed on December 11, 2009.

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9

60%

Year-Over-Year Changes in Gross Domestic Product Year-Over-Year Changes in S&P 500 Consumer Discretionary

50%

5.0%

30%

3.0%

20% 10%

2.0%

0%

1.0%

⫺10%

0.0%

⫺20% ⫺30%

⫺1.0%

Figure 1.2 Growth

2008

2007

2006

2005

2004

2003

2002

2001

2000

1999

1998

1997

1996

1995

⫺2.0%

Correlation: 68%

S&P 500 Consumer Discretionary

Gross Domestic Product

40% 4.0%

⫺40% ⫺50%

GDP and S&P 500 Consumer Discretionary

Source: Thomson Reuters.

When consumers are spending, the largest portion of the economy benefits—and vice versa. This relationship is the primary factor linking the sector so closely to economic growth. Figure 1.2 illustrates the relationship between economic growth and Consumer Discretionary stock price performance. You can clearly see Consumer Discretionary stock prices frequently rising and falling alongside the economy. Since consumer spending represents such a large portion of economic output, an understanding of its components and drivers is imperative to any analysis of the Consumer Discretionary sector. We’ll detail these factors in Chapter 3. High Correlations

In addition to being “The Great Humiliator” (see Ken Fisher’s The Only Three Questions That Count), the stock market can also be called “The Great Discounter,” as in discounter of future earnings. In other words, when investors expect earnings will be strong, broad stock market performance is typically positive. Investors are generally bullish

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Table 1.2 A Strong Relationship Industry

Correlation

Weight (%)

Media

0.90

50.5

Automobiles

0.80

5.7

Multiline Retail

0.76

16.2

Distributors

0.77

1.3

Specialty Retail

0.77

38.0

Hotels, Restaurants & Leisure

0.70

30.4

Average

0.62

N/A

Internet & Catalogue Retail

0.59

7.3

Auto Components

0.59

3.8

Textiles, Apparel & Luxury Goods

0.48

8.9

Leisure Equipment & Products

0.44

2.3

Household Durables

0.35

7.0

Source: Thomson Reuters, Standard and Poor’s, as of 6/30/2009.

on future earnings when trends in employment, wages, and spending are favorable or improving—the same conditions that favor Consumer Discretionary earnings. As a result, the Consumer Discretionary sector and its industries are highly correlated to broad stock market performance. Table 1.2 shows Consumer Discretionary 10-year industry correlations to the S&P 500 as of June 30, 2009. Comparing Consumer Discretionary industry correlations to the average industry correlation of the S&P 500 shows how closely related Consumer Discretionary performance is to the index, especially for the biggest constituents. Getting in the Mood

Another common feature of Consumer Discretionary stocks’ performance is how consumer sentiment can impact demand for a company’s goods or services. Let’s face it, happy consumers are good for the economy. A consumer with a positive economic outlook is more likely to buy a new car than one who thinks his job is in jeopardy.

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However, that same consumer is unlikely to buy an extra loaf of bread just because he got a raise and feels secure in his job. While not a fundamental driver, understanding how sentiment impacts demand for certain goods can help determine if a company fits in the Consumer Discretionary sector. Sentiment is measured by a variety of organizations. The Conference Board, the University of Michigan, and the Washington Post-ABC News each measure and publish various gauges of consumer confidence. The three major surveys use different methods and seek different information. For instance, the Conference Board surveys 5,000 households on a weekly basis to track how consumers feel about the job market and the economy. It pays little attention to expectations for household spending. The University of Michigan surveys 500 adults regarding their outlook on financial and spending matters, while the Washington Post-ABC News poll surveys 250 people on a weekly basis about current economic conditions. These inconsistencies result in a variety of indexes with often-disparate findings and rarely serve as a gauge of future stock market performance. However, it is important to understand the underlying message the sentiment indexes are conveying. Ironically, while the condition these surveys measure is powerful, the results of the surveys have little correlation with stock market performance. For example, Figure 1.3 compares the Conference Board’s survey of future stock market expectations with forward performance. The correlation is an insignificant 0.25. This isn’t to say expectations don’t matter—on the contrary! Figure 1.4 takes the same sentiment data and compares them with current stock market performance. The correlation is a much stronger 0.79. The explanation is simple: If consumers expect stocks to be higher (or lower) in 12 months, they will act accordingly today, not in 12 months. Although positive sentiment is typically a good sign for consumer spending, using sentiment as a forecasting tool is usually fruitless. The key is understanding trends. (The role of sentiment is discussed in more depth in Chapter 3.)

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Fisher Investments on Consumer Discretionary 60%

Net Confidence in 12-Month Stock Price Forward 12-Month S&P 500 Return

40%

20%

0%

⫺20% ⫺40%

2009

2008

2007

2006

2005

2004

2003

2002

2001

2000

1999

1998

1997

1996

Correlation: 25% 1995

⫺60%

Figure 1.3 Conference Board Future Stock Market Expectations vs. Future S&P 500 Returns Source: Thomson Reuters.

60% Net Confidence in 12-Month Stock Price Current S&P 500 Return 40%

20%

0%

⫺20% ⫺40%

2009

2008

2007

2006

2005

2004

2003

2002

2001

2000

1999

1998

1997

Correlation: 79% 1996

⫺60%

Figure 1.4 Conference Board Future Stock Market Expectations vs. Current S&P 500 Returns Source: Thomson Reuters.

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Black Friday Black Friday is the day after Thanksgiving and the official start to the holiday shopping season. Often cited as the busiest shopping day of the year, retailers typically extend hours and may dramatically reduce prices to drive shoppers into their stores. Before spreadsheets rendered hand-written income statements obsolete, accountants used to denote losses in red and profits in black. As the story goes, Black Friday got its name because it was the first day of the year retailers overcame their fixed costs to go “into the black.” Seems straightforward, but there’s another explanation for the name, tracing back to 1966 and cranky Philadelphia policemen. Griping about massive traffic jams and overcrowded sidewalks, local police began referring to the day as “Black Friday” in relation to the headaches it caused, not the profits it created. Also, according to the International Council of Shopping Centers, an industry trade group, Black Friday is typically not the busiest day in terms of sales. While it is consistently in the top 10, the weekend before Christmas tends to see stronger sales. As online retailing has grown, the Monday after Thanksgiving—“Cyber Monday”—has grown in significance too. Finally, although the holiday season typically generates the largest profits of the year, most retailers are profitable all year long. Source: The American Dialect Society, International Council of Shopping Centers.

GETTING TO KNOW THE CONSUMER DISCRETIONARY SECTOR Now that you know some of the high-level commonalities of the sector, you can begin to understand each of the sector’s industries. Remember, this is a broad overview—Chapter 4 addresses the sector’s constituents in much more depth. Automobiles & Components

The Automobile industry has long been a symbol of ingenuity and prosperity. As a means of transportation and a major piece of manufacturing infrastructure in global economies, the automobile can be both a means of growth and a symbol of wealth. Automobile manufacturers and component suppliers are included in this industry.

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Automobile manufacturers, also known as original equipment manufacturers (OEMs), produce automobiles for both private and commercial use. Passenger cars and light trucks are the primary types of vehicles these firms produce. Component manufacturers supply automobile manufacturers with everything from tires to stereos to airbags. In periods of strong economic growth, demand for automobiles is stronger as disposable income supports purchases of new automobiles (and the underlying components). Cyclicality in demand is intuitive to grasp; however, earnings volatility can be immense as fixed manufacturing costs are high. The larger and more expensive an item, the less likely a consumer is to commit to a purchase if his or her outlook is sufficiently bleak. Therefore, sentiment plays a large role in automobile demand. Retailing

The retail industry is possibly the most recognizable industry in the Consumer Discretionary sector. From Home Depot to Neiman Marcus, Target to Williams Sonoma, the retail industry provides consumers with many of the goods used in daily life. There are two types of retailers: Multiline and Specialty. Multiline retailers come in two forms: department stores and general merchandisers. Department stores sell a wide variety of goods, but focus primarily on apparel and cosmetics. General merchandisers provide a wider selection of goods and may include certain nondiscretionary items like groceries. Nordstrom and Macy’s are examples of department stores, while Target and Kmart are general merchandisers. Wal-Mart is excluded from this group because it sells a large proportion of groceries that are not economically sensitive. Specialty retailers emphasize one category of goods. Best Buy and Home Depot are good examples. The former sells a wide variety of consumer electronics, while the latter specializes in home improvement supplies. Since these companies carry such deep selections of one category, they are referred to as “category killers” because competing general merchandisers often lose sales of entire merchandise categories to these companies.

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The link to consumer spending and sentiment is evident in the Retailing industry group. When spending is strong and sentiment is positive, retailers are often able to sell more items and at higher prices. This relationship supports one of the highest correlations to overall stock market performance of all its Consumer Discretionary sector peers. Media

The Media industry includes Advertising, Publishing & Broadcasting, Cable & Satellite, and Movies & Entertainment firms. Firms in this category create and distribute content—feature films, television shows, advertisements, books, newspapers, and music, among others. Revenue is primarily generated via advertising, subscription fees, book or magazine sales, and box office sales. Each sub-industry focuses on a different type of revenue. For instance, a broadcaster generates the majority of its revenue by selling advertising space, while a cable company relies primarily on monthly subscriber fees. These firms fit the criteria we introduced earlier in the chapter. Specifically, revenue is driven by demand for advertising and by strong consumer spending. A growing economy supports both conditions. Additionally, profits are highly cyclical. The fixed costs associated with running a newspaper or producing a movie are immense—in the event of an economic downturn, profitability is quickly impaired. Finally, when sentiment is weak and consumers are not spending, advertising is less profitable. This reduces demand for advertising and diminishes earnings. Consumer Durables

As its name implies, this industry produces consumer goods meant for durable use (“durable” goods are designed to last more than three years). Appliance manufacturers, homebuilders, and consumer electronics firms are included here. Appliance manufacturers produce a variety of goods to meet new and replacement demand. These firms manufacture major appliances

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(refrigerators, washing machines), smaller appliances (microwaves, toasters), and home furnishings (dining room sets, bedroom furniture). Intuitively, homebuilders build homes after investing in land and local infrastructure. Consumer electronics firms manufacture electronic goods—televisions, home theater and audio, and a variety of other consumer-focused items. Not long after purchasing a new home, many consumers purchase new appliances and home theater products. Because the purchase of a new home is driven by growth in disposable income, economic expansion, and favorable interest rates, demand for durable consumer goods is leveraged to economic growth. Considerable fixed costs— both in the form of manufacturing facilities and, in certain cases, research and development—provide significant operating leverage and magnify earnings cyclicality. Since durable goods are often big-ticket items requiring financing, sentiment and interest rates play a large role in driving demand. Consumer Services

Hotels, Restaurants & Leisure are the main categories in this industry group. The lodging industry provides accommodations for leisure and business travelers. Hotels come in a variety of formats, including ownership, management, or franchised. Deciding whether to own or franchise in the restaurant industry is also important. The leisure industry includes theme parks, cruise lines, and travel agencies. These companies provide accommodation and planning services to a variety of consumers. Business activity and consumer spending are the primary drivers of revenue in this segment. These firms enjoy strong earnings growth in expanding economies and face significant declines in weakening economies. Like other industries within the sector, spending on travel is leveraged to sentiment as expectations of an impending layoff will generally prevent households from booking a major vacation.

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Chapter Recap By now you should have a basic understanding of what kinds of companies comprise the Consumer Discretionary sector. Understanding the characteristics these companies share is vital to your understanding of the broader sector and will be the foundation this book builds on. You should also be familiar with what types of companies are included in the sector and how these firms fulfill the identifying criteria we’ve introduced. • The Consumer Discretionary sector is a part of your everyday life, although identifying what is included and what isn’t can be counterintuitive. • The sector can be volatile owing to its leverage to economic growth and consumer spending. • Demand for Consumer Discretionary goods and services can be dependent on consumer sentiment. • There are five basic categories of Consumer Discretionary stocks: Media, Retail, Automobiles, Consumer Durables, and Consumer Services.

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2 THE HISTORY OF THE CONSUMER DISCRETIONARY SECTOR

C

alling the US a nation of consumers is hardly provocative— consumer spending makes up about 70 percent of its economy. But the US isn’t alone—consumption drives the world economy and has done so for centuries. What humanity consumes—and how—has played a pivotal role in shaping modern societies.1 Businesses trying to harness this massive force invest heavily to meet and, in certain cases, create consumer demand. The resulting capital investment creates jobs and sure enough, more consumers. A history of consumers could start with the early Romans or even Mesopotamians, but for our purposes, a more useful exercise is looking at the roots of more “modern” consumers, particularly in America. For that, we start with the trade relations between Native Americans and colonists in the 1600s. This period not only played a significant role in expanding early economies, but provides historical context for the modern Consumer Discretionary sector.

19

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THE EARLIEST AMERICAN CONSUMERS Consumption in the US goes back to well before the 1980s enclosed mall craze, before the 1920s explosion of household appliance innovations, before Henry Ford’s mass production of automobiles, even before the Industrial Revolution. In America, we can trace back to the formation of the Jamestown Colony in 1607—more specifically, to the emergence of the Native Americans as savvy participants in booming global trade. The Settlement at Jamestown

Following Columbus’s landing on San Salvador, European governments swiftly established trading outposts and eventually, colonies in the resource-rich land. Jamestown, an English colony in America, was located on a swampy peninsula without access to fresh water and disconnected from significant game herds. Captain John Smith reported about half of the colonists were “gentlemen” and unfit for building and maintaining a self-sufficient colony. After some false starts and a near abandonment, Jamestown’s salvation came in the shape of politically treacherous seeds. Tobacco—especially the Nicotiana tabacum strain—was a highly sought and highly profitable crop at the time. Jamestown colonist John Rolfe acquired the seeds under penalty of death from the Spanish government, who had a monopoly on the strain.2 Within two years, tobacco was exported to England in vast quantities, making Jamestown the region’s dominant settlement. Prior to tobacco, colonists traded relatively little with their nearby neighbors, the native Powhatan tribe. The colonists, whose own crops were unsuccessful, tried to trade for food. But they had little to offer their better-equipped neighbors. However, tobacco trade with Europe generated enough wealth to develop local manufacturing facilities, and Jamestown began producing iron tools, glass, and textiles. Although the colonists knew the Native Americans had a healthy appetite for iron tools like axes, hatches, and awls, nothing could prepare them for the economic expansion the next several decades would provide.

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Native Americans—Global Traders

Although fur trading is most often associated with the French, the early English colonies in Virginia were the continent’s largest fur traders, thanks to the trapping expertise of Virginia’s Native American tribes.3 By the early 1600s, fur demand from Europe was exploding—dwindling European herds improved the economics of shipping furs from the colonies. Fur trade in Jamestown grew quickly as the combination of tobacco profits and a wealth of locally manufactured goods provided a sound foundation for trade. Per capita wealth of Native Americans grew rapidly in the early 1600s.4 Between 1660 and 1700, British exports to North America of woolen textiles, silverware, and sewing machines—all popular among Native Americans—skyrocketed. But fur hunting wasn’t a steady cash-flow business—there was a lag between commissioning a hunting party and realizing profits from the hunters’ catch. So trappers and traders turned to an age-old solution—credit. This smoothed out the cash-flow problems for the Native Americans and boosted demand for discretionary goods produced and/or distributed by the colonists. Unfortunately, economic growth has been cyclical since the dawn of time. Profits from the fur trade began to wane. To pay off mounting debts, Native Americans began selling their game lands to farmers. Some tribes sold themselves as mercenaries. Others waged war against their creditors, as in the Yamasee War of the early 1700s. Changing fashions in Europe and declining yields in America meant the fur trade would never again be as profitable as it once was. The American and Consumer Revolutions

Looking to acquire new game lands, French and English interests laid claim to present-day Ohio. Skirmishes among competing powers erupted into the French and Indian War in 1754. British forces arrived to protect their interests, and, for the first time, British officers and common soldiers saw the transformation of the colonies’ wealth over the last hundred years. No longer a wilderness frontier, the colonies

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Taxation, Boycotts, and Tea The French and Indian War nearly doubled Britain’s national debt to $129 billion, up from $72 billion less than 10 years earlier.5 To raise money, Britain’s Parliament decided the newly wealthy colonies were an attractive revenue source and enacted a number of taxes on colonial consumption—from sugar to stamps. The colonists were outraged. The Massachusetts and New York governments sent letters to Parliament protesting the new tax, but to no avail. Realizing their governmental impotence, the colonists found a new way to protest: the boycott. Colonists of all ilk closed their wallets to British goods. In response, Britain imposed taxes on all legal documents, permits, contracts, even wills. Increasingly aggressive, the colonists burned the home of a British tax collector and infamously vented their anger on some crates of tea. The Brits couldn’t collect taxes on goods that didn’t sell (or got too soggy). Soon, consumer revolt turned into outright war, and the American Revolution was under way—a nation created, in part, by consumers exerting their will for better goods at more reasonable prices.

showcased rich plantations owned by wealthy farmers. But the British were particularly surprised at the apparent wealth of the middle class. England quickly discovered the New World’s value lay not only in its vast resources, but also in its wealthy consumers. The Industrial Revolution and the Modern Consumer

But there was another revolution brewing. The marriage of invention and mechanization birthed the Industrial Revolution—first in Europe, then in America—which laid the foundation for tremendous growth for centuries to come. In Europe, grain mills and textile manufacturing were among the first industries to be mechanized, leading to wholesale improvements in efficiency and output. Profits soared, particularly in Britain. Because its competitive advantage relied on proprietary designs, Britain enforced strict laws against the export of skilled labor. Indeed, visitors to its new and bustling factories were allowed to look but not take

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notes as factory owners and politicians alike were concerned the value of its technological breakthroughs would be diminished by copycats. But no good secret is ever kept. Oliver Evans and Eli Whitney were among the first American inventors to mechanize labor-intensive industries. Evans designed the first semi-automated, water-powered grain mill. Eli Whitney built the cotton gin (a machine to remove seeds from raw cotton). Whitney’s invention reduced manual labor associated with refining cotton by a factor of 50. Profits for Southern farmers soared. These inventions and the resulting profits did not go unnoticed. Between 1860 and 1890, more than 400,000 patents were issued to inventors.6 With industrialization came rapid employment growth. Agricultural improvements led an exodus of farm workers to urban centers. From 1870 to 1890, the number of people employed in manufacturing, transportation, public utilities, and construction more than doubled.7 Meanwhile, a flood of European immigrants chasing jobs (plus, undoubtedly, liberty and the pursuit of happiness) helped America’s population more than double from 31.5 million in 1860 to 76.1 million 1900.8 Cheap production and a growing working class gave birth to a host of new industries, many of which are now a part of the Consumer Discretionary sector. THE BIRTH OF THE MODERN CONSUMER DISCRETIONARY SECTOR Rapid industrialization led to innovation at exponential rates and increasing aggregate wealth. With wealth came demand and a literal explosion of new goods and services for the burgeoning “middle class.” Each of the five industry groups comprising the modern Consumer Discretionary sector can be traced in this period, including: • • • • •

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Media Retailing Automobiles & Components Consumer Durables & Apparel Consumer Services

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Media

Nineteenth-century media was primarily newspapers and books, but toward the end of the century it incorporated advertising and motion pictures. Newspapers and books had been around for centuries in some form, dating back to Julius Caesar’s publications of Acta Diurna and possibly before. But widespread and rapid production and distribution of content began with advancements in print and transportation technology in the 1800s. Read All About It—The Newspaper Boom At the end of the

Revolutionary War, there were 43 newspapers in the nation. By 1814, there were 346. By 1830, advancements in papermaking and print technology allowed publishers to charge just a penny per issue. The success of the “Penny Press” contributed to a print pandemic. By the late 1800s, there were thousands of papers, and media giants like William Randolph Hearst started consolidating the very fragmented industry. In addition to breakthroughs in printing technology, other innovations contributed to industry growth. Once upon a time, carrier pigeons delivered news to France from other parts of Europe. In 1851, the telegraphed linked England and continental Europe, allowing speedy reporting from abroad. Motion Pictures, Before Hollywood Advancements in film tech-

nology led to the development of another content-based industry— motion pictures. Single exposure cameras had been around for years. Early innovations in the mid-1800s took still pictures and rotated them through a projection lens, giving the illusion the still images were moving. But consistently producing high-quality exposures was often a time-consuming process, and taking a continuous stream of photographs remained a hurdle to making films look real. In 1899, American inventors George Eastman and Hannibal Goodwin developed a revolutionary new type of camera. Using pieces of rapid-exposure film attached to a celluloid strip, their camera allowed a steady and consistent stream of pictures to be taken and stored in an attached reel. A few years later, a predecessor of today’s film projector

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was invented by Thomas Edison and his employee William Dickson. Their invention (the Kinetoscope) used a backlight and a magnifier to project a reel of film on a movie parlor screen. This innovation made motion pictures accessible to larger audiences and kicked off further development of film projection technology. America’s first major motion picture was The Great Train Robbery—released in 1903, a 10-minute, one-reel silent film. In 1926, Time Warner released the first “talkie,” The Jazz Singer, to immediate success. The next few decades of soaring profits for film studios drove continued innovation in film and sound quality, dramatic content, and cinematography. All the while, non-stop innovation kept the price of admission cheap. By World War II, the industry was providing cheap entertainment globally, and that remains true today. Retailing

The retail industry is based on a simple, ancient premise: Sell goods for more than it cost to procure them. It’s hardly a new idea, but transformative innovations occurred during the Industrial Revolution. First, the variety of goods offered in stores improved as technological improvements in agriculture and manufacturing made goods cheaper. And second, transportation improvements allowed goods to be shipped greater distances. By the 1830s, railroads were shipping massive quantities of goods from city to city. For the first time, products made in Boston could be in Savannah in a few days. But America was a massive, far-flung nation. Peddler-turnedcountry-store-owner Aaron Montgomery Ward found a way to make even the most remote outpost a consumption powerhouse. Capitalizing on breakthroughs in publishing technology and faster mail—thanks to the railroads—Ward realized he could undercut his competition by selling directly to customers using a catalogue. He didn’t need a local outlet to sell his wares—just a mailing address. He wasn’t the first to sell by catalogue (Benjamin Franklin sent out a catalogue in 1744), but he was arguably the first to do it so successfully in large scale. Montgomery Ward’s success with the catalogue drove new innovations in existing department stores, whose businesses were located in

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population centers and sold primarily dry goods. By the late-nineteenth century, American department stores combined elements of Ward’s expansive product selection and catalogue format with France’s similarly unique operations. Frenchman Aristide Boucicaut opened Le Bon Marché in 1838, emphasizing distinct departments within the store that offered a variety of goods beyond simple necessities and provisions. He encouraged consumers to visit the store and shop around even if they were unlikely to buy. He fixed the prices of his goods so there was no haggling. And today, “going shopping” can still be an entertainment unto itself, just as M. Boucicaut envisioned. Automobiles & Components

Even by the Industrial Revolution, individual locomotion had come a long way since inventor Al-Jazari first described an early internal combustion engine in 1206. His design was the first to describe the conversion of vertical piston movement into rotational force via a crankshaft and connecting rods. Over the next several hundred years, inventors experimented with various fuels, including gun powder and hydrogen, but were largely unsuccessful until German inventor Nikolaus Otto designed the world’s first four stroke engine in 1876. The four stroke cycle materially increased the power of internal combustion engines, thanks to its ability to pressurize incoming air and fuel, and is still used by most modern engines today. Automotive innovations were progressing rapidly by the turn of the nineteenth century, with now-familiar names like Daimler, Maybach, and Benz all contributing to automotive revolutions. But significant obstacles stood in the way of mass adoption. Infrastructure—like roads and gas stations—lagged behind. But more important, most found automobiles too cost-prohibitive. And no wonder—they were largely hand-built, one at a time. It wasn’t until 1894, when Benz & Cie. standardized the Benz Velo, that automobiles were produced identically. This development brought a slew of competitors to the market, including Peugeot, Olds Motor Vehicle Company (later Oldsmobile), Duryea Motor Wagon Company, and the Detroit Automobile Company (later Cadillac).

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In 1903, Henry Ford founded Ford Motor Company with some initial successes. But his lasting fame would be inspired by a visit to a slaughterhouse, where a Ford employee observed the efficiency of workers disassembling animals on a conveyor belt. Soon, Ford engineers developed an “assembly line” manufacturing process where parts were moved along a conveyor belt from worker to worker. Each worker was responsible for a singular task, like attaching a mirror or securing a hose on the radiator. This process, combined with breakthroughs in metallurgy, allowed Ford to dramatically increase the affordability of the new Model T. Ford’s Model T was the first car to be built using standardized parts, newer and lighter-weight metals, and the assembly line. The earliest models, produced in 1908, sold for $825 (about $20,000 in today’s dollars). By 1914, Ford’s plants produced a car every 93 minutes.9 Soon, society and infrastructure began to catch up to automotive technology—improvements like heating, stereos, anti-freeze, and fourwheel braking were introduced. Additionally, increasing industrial trade and the prevalence of automobiles spurred national road construction and the passage of the Federal-Aid Highway Act of 1956 to build the interstate highway system. Society was quick to note the transition of the automobile from a luxury toy to a necessity. Drive-in restaurants, suburban development, and highway motels all stemmed from the rapid growth in the automotive industry. Seatbelts first appeared in the 1950s and were offered on most vehicles by the 1960s. A decade later, Chrysler introduced the first airbags, further improving automotive safety. Automotive innovation accelerated over the decades, featuring onboard computers, greater safety features, speedier production times, and new management philosophies. And though America was once the automotive powerhouse of the world (and remains a force to be reckoned with in trucks and SUVs), management missteps, union demands, fuel-efficiency regulations, and competition from innovative foreign automakers have all led to America losing relative standing. With two long-standing auto manufacturers—General Motors and Chrysler—having gone through bankruptcy reorganization in 2009 and tougher emissions regulations on the way, America’s automakers

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may never regain their footing. But there’s plenty of innovation going on in other markets to make up for it. Consumer Durables & Apparel

The modern Consumer Durables industry group is broad—homebuilders, appliance makers, tool makers, textile manufacturers, and consumer electronics are all a part of the group. Mechanization of textile manufacturing revolutionized the early apparel industry; however, the most impactful innovation for the industry—and potentially the entire industrial economy—was the introduction of interchangeable parts. The Textile Transformation In the early 1700s, Britain was heavily reliant on textile manufacturing—wool products exports represented a big chunk of GDP. But wool manufacturing was labor intensive. Early innovations, like the flying shuttle in 1733, increased weaving output by expanding the width of the cloth. Later inventions in spinning frames, and then using water and steam-powered engines to drive them, dramatically improved yarn production. Textile innovation kicked off in Britain, but it was American inventor Eli Whitney who invented the cotton gin—increasing the amount of cotton a worker could deseed by 50 times. Improvements in yields combined with increasing demand produced strong profits for nearly a century before production costs in developed countries made outsourcing preferable. Today, most US textile manufacturers rely on factories in Southeast Asia. Interchangeable Parts While textile manufacturing was an early

mover in the Industrial Revolution, the most impactful innovation wasn’t a gadget, per se—rather, it was a methodology. Guns in the eighteenth century were made one by one by gunsmiths, requiring several skilled workers to produce a single weapon. Once complete, they’d start over from scratch and build another. And another. Since each gun was unique, repairs were often so burdensome (guns had to be shipped to the actual gunsmith for repair) that broken weaponry was frequently simply discarded.

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Taking a cue from clockmakers in the 1700s, gunsmith Honoré Blanc realized if he could build a gun with identical dimensions and identically produced components, he could quickly assemble or repair the finished product. This new way of thinking quickly revolutionized manufacturing across nearly all industries. Still, parts were largely produced by hand for later use in standardized assemblies. What was missing was a way to mechanize production of standardized components—until Simeon North used a milling machine, produced by Eli Whitney, to standardize metal components for weapons. This sparked the mass production era of the 1800s. With the ability to produce identical components came the power to set and measure standard distances and tolerances with gauges and calipers. These innovations allowed mass production of all kinds of consumer goods, dramatically reducing the costs of sewing machines, typewriters, small engines, and any other good requiring precision manufacturing. Indeed, many of the early innovators in standardization are some of today’s largest tool makers. Stanley Works got its start making standardized screws for doors. Black & Decker invented the world’s first portable, trigger-action drill. The company responsible for the nation’s first milling machine, Browne & Sharp, is now a part of Hexagon Metrology, one of the world’s leading ultra-precise measurement providers. With standardized tools and components came the potential to build all sorts of previously inaccessible consumer goods for the masses. Electric washing machines, vacuum cleaners, and refrigerators were all late-nineteenth century inventions. Appliance makers Maytag, Hoover, Whirlpool, and General Electric got their start inventing electrical appliances in the late-nineteenth and early twentieth centuries. Interestingly, much of the growth during this period was financed by electric utilities. The way they saw it, by helping appliance makers market new electric appliances, the increased power demand would fund development of new power grids. Appliances and the Great Housing Boom Of course, product

innovations and marketing were not the only factors driving demand

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for appliances. Population growth and increasingly affordable housing contributed to rapid household formation, a key demand driver for appliances. The history of homebuilding largely follows the development spurred on by the Industrial Revolution. Breakthroughs in transportation, technology, and industry (roads and rails, steam engines, electricity, steel production, better construction methods) all made homes cheaper and easier to build—and more comfortable to live in. While building residential dwellings is an ancient practice, the modern industry finds its roots in the significant technological breakthroughs and governmental homebuilding support of the nineteenth and twentieth centuries. One of the earliest homebuilders was Sears—sort of. Already a successful mail-order catalogue business, one of Sears’ weakest selling categories was building materials. One of Sears’ managers, Frank Kushel, suggested to Richard Sears the company sell entire homes via the catalogue by shipping prefabricated, standardized components directly to customers, complete with directions. Though not the first to offer homes via mail (the Aladdin Company was first in 1906), Sears had significant distribution already in place, thanks to its preexisting catalogue. Sears estimates it took 40 percent fewer carpenter hours to assemble its homes because of its standardized materials. Its immense purchasing scale afforded it lower variable costs than peers, which, when combined with the use of new innovations like asphalt shingles and drywall in addition to its ability to offer financing, gave Sears a tangible competitive advantage over its peers. Eventually, Sears fell victim to loose loan policies and the Great Depression, a combination that knocked Sears out of the homebuilding business by 1940, after having sold over 100,000 homes since 1908.10 The postwar economic expansion, boosted by the GI Bill, drove significant growth in the homebuilding industry. With American soldiers back from war and the US Department of Veterans Affairs issuing home loans to returning soldiers by 1944, it took just four years to increase annual home construction from 142,000 in 1944 to 1.2 million in 1948.11 As homebuilding accelerated, so too did sales of home appliances.

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In addition to accommodative loan policies for veterans, the Baby Boom was in full swing, peaking at 4.3 million births in 1957. Increasingly cheaper transportation, combined with governmental programs like the Department of Housing and Urban Development (1965), only fueled the housing fire. The 1970 establishment of the Federal Home Loan and Mortgage Corporation (Freddie Mac) increased banks’ ability to offer loans, boosting homeownership. The nation’s 100-millionth home was built in 1987. Today, regional homebuilders compete with national players for a piece of the nation’s nearly 70 percent homeownership. Consumer Services

The modern Consumer Services industry group includes tourism (cruise lines and travel agencies), lodging (hotels and motels), and restaurants (both fast food and full service). It also includes a category called Specialized Consumer Services (barber shops, beauty salons, tax services, even funeral homes), but this overview will primarily cover the Hotels, Restaurants, & Leisure industry. The tourism industry is quite ancient. Tourism rapidly accelerated during the Industrial Revolution and, because tourists require lodging, so too did the hotel industry. The first modern hotel in the US is believed to be New York’s City Hotel, opened in 1794. The first building to exclusively offer lodging, its 73 rooms catered to New York’s rapidly expanding population and economy.12 Many entrepreneurs copied this format, and by 1829, the world’s first luxury hotel— Boston’s Tremont House—offered amenities like private rooms, free soap, fresh water, a bellboy, and gourmet cuisine. Still mostly owned and operated by independent businessmen, the first commercial hotels showed up in the early twentieth century. Some of the nation’s best-known hotels were built during this period, including the Chicago Hilton, New York’s Waldorf-Astoria, and the Hotel Pennsylvania. A massive expansionary period took place in the 1950s and 1960s as the franchise model caught on. Established operators franchised their names to existing independent operators in

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return for a share of the hotel’s profits, allowing a company to rapidly expand its hotel footprint without investing much new capital. The final piece of the Consumer Services industry group is Restaurants. With the Industrial Revolution in full swing by the late nineteenth century, workers needed a fast and affordable way to get a meal. By 1872, the concept of the “Lunch Wagon” had caught on—a wagon with a variety of pre-made or ready-to-be-made meals available. Fred Harvey, realizing rail passengers often had little more than 20 minutes at a stop to get food, began building restaurants along major rail lines and focused on producing enough meals for an entire train of people in less than 20 minutes. His concept, called the “Harvey House,” was the first modern fast-food restaurant and immortalized in the 1946 musical The Harvey Girls starring Judy Garland. The “fast food” concept gained acceptance as railroads and eventually highways connected the nation. White Castle modified the Harvey House approach, selling miniature burgers to motorists on the go and inventing new products like the crush-resistant box. By 1921, a candy wholesaler named JG Kirby invented the drive-through window, announcing, “People with cars are so lazy they don’t want to get out of them to eat!”13 The modern fast-food industry was born. Today, most people associate fast food with industry-giant McDonald’s. Originally founded in 1940 in San Bernadino, California, McDonald’s is by far the world’s largest restaurant company. Seeing a rise in restaurant franchising along new highways, a salesman named Ray Kroc bought his first McDonald’s franchise in 1954 after visiting the firm’s headquarters on a sales call. Relying on franchising to rapidly expand the business, Kroc bought out the McDonald brothers in 1961 and left the business largely unchanged. Selling basic burgers and fries at low prices and maintaining strict quality reinforced the McDonald’s experience. Its key strategy was to ensure a Big Mac in Minneapolis tasted the same as a Big Mac in Phoenix. Kroc’s timing was perfect. Nationally funded highway construction provided ample high-traffic locations for rapid and lucrative development, and the company’s success led to the entrance of several new fast food competitors like Taco Bell, Carl’s Jr., and Burger King.

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Chapter Recap As the Industrial Revolution drove significant increases in wealth, consumer demand for discretionary goods grew. Improving manufacturing efficiency made consumer goods more affordable and provided the foundation upon which much of the modern sector is built. • The Industrial Revolution increased the availability of all kinds of consumer goods while reducing prices and generating enormous economic growth. • Most of the modern Consumer Discretionary sector was established in the late nineteenth and early twentieth centuries as many ancient consumer-focused businesses benefited from new technologies.

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3 CONSUMER DISCRETIONARY SECTOR DRIVERS

I

n this chapter, we’ll outline the most important macro drivers for the Consumer Discretionary sector. These are grouped into three broad categories you can use to examine the sector’s forward-looking prospects: • Economic drivers • Political drivers • Sentiment drivers We’ll start by assessing the economic drivers most applicable to Consumer Discretionary. For illustration, much of this discussion will center on the US, but the principles can be applied to any country. And fortunately, today, the same (or similar) economic releases analysts study to understand drivers for US stocks are readily available for most other developed nations, and even many emerging nations. It’s quite simple to get GDP data for the UK, Germany, Japan, etc. And many organizations—like the International Monetary Fund (IMF) 35

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and the Organisation for Economic Co-operation and Development (OECD)—gather data on global conditions and publish them, for free, on their websites. Also, because the Consumer Discretionary sector is so diverse, this chapter only addresses sector-wide drivers. Industry-specific drivers will be covered in Chapter 4. ECONOMIC DRIVERS Macroeconomic indicators take the pulse of the economy. Whether it’s non-farm payrolls, durable goods orders, interest rate announcements, or gross domestic product (GDP) releases, these reports matter because they reflect the economic environment. Deciphering the data may not be easy, but understanding the relationships between economic data and Consumer Discretionary sector performance is key. Some of the most meaningful economic drivers for the Consumer Discretionary sector are: • • • • •

Consumer spending Income and employment Economic growth Interest rates Currency

While there are many more drivers, these are generally the most important. And how these impact the sector can vary depending on other economic conditions. Simply, no driver functions in a vacuum. When examining drivers for this and any other sector, they should be considered in context of broader economic conditions. That said, perhaps the most important Consumer Discretionary driver is consumer spending. Consumer spending itself is driven by employment and wage growth—all of which are driven by economic growth. Interest rates and currency fluctuations can also play an important role in driving demand for Consumer Discretionary stocks.

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Economic growth is, generally, the most important driver for most sectors that are economically sensitive or have elastic demand. But because consumer spending is so central to the Consumer Discretionary sector—and most directly impacts Discretionary firms’ performance— we’ll start with that one.

The Great Discounter The figures in this chapter illustrate an important phenomenon we keep mentioning— stocks perform based on expectations of tomorrow, not on developments today. In Figure 3.1 for instance, notice how consumer spending appears to lag sector performance. This is because investors are discounting where they think consumer spending will go. How do they do it? By following the logical—yet not always intuitive—steps we outline in this book, specifically this chapter. They consider current conditions, look at history, determine where spending is likely to go, and come to a conclusion about how their forecast will impact Consumer Discretionary earnings and stock prices—the mission of this book. 40%

6.0% 5.0%

20%

4.0%

10%

3.0% Sector performance begins to weaken before spending does.

0%

2.0%

⫺10%

1.0%

⫺20% ⫺30%

2008

2007

2006

2005

2004

2003

2002

2001

2000

1999

1998

Year-Over-Year Change in S&P 500 Consumer Discretionary Rolling 12-Month Average of Year-Over-Year Changes in Consumer Spending 1996

⫺40%

0.0%

Sector performance improves before spending does.

Sector performance stabilizes before spending does.

1997

S&P 500 Consumer Discretionary

30%

⫺1.0%

Total Consumer Spending (12-Month Moving Average)

Sector performance weakens before spending does.

⫺2.0%

Figure 3.1 Consumer Discretionary Performance Leads Consumer Spending Source: Bureau of Economic Analysis, Thomson Reuters, as of 6/30/2009.

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Consumer Spending

Not all consumer spending is created equally. The Bureau of Economic Analysis (BEA) publishes quarterly data on consumer spending and breaks it into three categories: • Durable goods • Non-Durable goods • Services The Consumer Discretionary sector is impacted by all types of spending to varying degrees. Durable goods are items designed to last more than three years, like cars, washing machines, televisions, and tools. Non-durable goods are items designed to last less than three years, including food and apparel. Services include expenditures for health care, education, debt service, and hospitality. Figure 3.2 breaks down how much of total consumer spending is on durable goods, nondurable goods, and services. As you can see, services are the largest portion by far, totaling 66 percent of total spending, with non-durables then durables making up the remaining 22 and 12 percent, respectively. 12%

22%

66%

Consumer Spending: Durable goods Consumer Spending: Services Consumer Spending: Non-Durable goods

Figure 3.2

Breakdown of Consumer Spending

Source: Bureau of Economic Analysis, Thomson Reuters, as of 6/15/2009.

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39

Historically, different types of spending have had differing impacts on industries. It’s therefore worthwhile to break down the different spending types. But first, to better understand how spending impacts this or any sector, it’s important to put to rest a common misperception about consumer spending. Many believe consumer spending is highly volatile, and because it makes up about 70 percent of GDP, a slowdown in consumer spending can cripple the economy. However, a look at history shows total consumer spending is far more steady than people assume, even during recessions. As of this writing, it’s likely the US economy bottomed in Q2 2009. Peak to trough, the economy fell 3.8 percent. As Figure 3.3 shows, in terms of contribution to the overall GDP decline, consumer spending contributed just 1.2 percent to the decline while falling exports and business investment contributed 1.9 percent and 3.4 percent, respectively. In fact, personal consumption as a percent of GDP typically grows during a recession because the other parts fall so much more, as shown in Figure 3.4. In the recessions indicated on the graph, spending as a percent of GDP gained.

4.0% ⫹0.5%

Contribution to Decline in GDP

3.0% 2.0% 1.0%

⫺0.8% ⫺1.2%

⫹3.0%

⫺1.9%

0.0% ⫺1.0% ⫺2.0% ⫺3.0%

The sharp reduction in exports and business investment accounts for majority of the net GDP.

⫺3.4%

⫺3.8%

⫺4.0% ⫺5.0%

Figure 3.3

Imports

Government Residential Personal Investment Consumption

Exports

Business Total Decline Investment in GDP

Contributions to Q2 2008–Q2 2009 GDP Decline

Source: Bureau of Economic Analysis, as of 6/30/2009.

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Fisher Investments on Consumer Discretionary 72% Consumption tends to be farily stable, rising relative to GDP in recessions.

2000 –'01

70%

68% 1990 –'91 66% 1981–'82 64%

1973 –'74

62% NBER Recession Consumption as % of GDP

09 20

05 20

01 20

97

93

19

89

19

85

19

19

81 19

77 19

73 19

69 19

65

61

19

57

Figure 3.4

19

19

19

53

60%

Private Consumption as a Percent of US GDP

Source: Bureau of Economic Analysis, as of 6/30/2009.

How can that be? It’s simple math. If the majority of spending is on services (like health care), which are much less sensitive to the economy, then total spending will be less economically sensitive (and volatile) than people think. This isn’t to say certain parts of consumer spending aren’t volatile; indeed, spending on durable goods can (and does) fluctuate dramatically. And although spending on durable goods is one of the most important Consumer Discretionary drivers, it represents just 12 percent of total consumer spending and 8 percent of total GDP (as of June 30, 2009).1 Durable Goods Since the majority of Consumer Discretionary companies produce or sell durable goods, we’d expect a significant relationship between growth in durable goods spending and Consumer Discretionary performance. Often referred to as “big-ticket” items, durable goods are designed to last a long time, may be expensive and require financing, and represent major outlays. Since durable goods require large financial commitments from consumers, spending on these items is often the first to be cut in a downturn and last to recover when the economy rebounds. In other words, they’re highly discretionary.

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Table 3.1 Durable Goods Spending and Consumer Discretionary Industry Group Performance Industry Group

Correlation

R-Square

S&P 500 Retailing

0.71

0.51

S&P 500 Autos

0.62

0.38

S&P 500 Media

0.61

0.37

S&P 500 Services

0.43

0.19

S&P 500 Durables

0.43

0.18

S&P 500 Consumer Discretionary

0.69

0.47

Source: Bureau of Economic Analysis, Thomson Reuters from 1/31/1995 through 6/30/2009.

Table 3.1 shows the relationship between durable goods spending and Consumer Discretionary industry group performance over the last 15 years. The relationship is strong—the correlation is 0.69 with an R-squared of 0.47. Individually, the Retailing industry group is most correlated—many of these firms sell more durable goods like tools and televisions (although they do sell many non-durable goods too). Autos also have a strong relationship. (Remember, correlations show the past, not necessarily what we can expect from the future. Still, they are useful in helping inform us what is reasonable to expect.) Ironically, the Consumer Durables industry group has the smallest correlation to durable goods spending. Because Consumer Durables firms (like homebuilders and appliance manufacturers) sell a larger portion of big-ticket items than peers, other factors like interest rates and sentiment play a more important role in their performance than simple spending trends. Additionally, Consumer Durables companies rely on sales made to retailers and distributors, which can be influenced by factors unrelated to demand—like adjustments to retail inventory levels, for instance. Non-Durable Goods Non-durable goods are primarily consum-

ables like food and alcohol, but also include products produced and sold by Consumer Discretionary companies like clothing and newspapers. Although not nearly as economically sensitive as durable goods

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Table 3.2 Non-Durable Goods Spending and Consumer Discretionary Industry Group Performance Industry Group

Correlation

R-Square

S&P 500 Retailing

0.70

0.49

S&P 500 Media

0.68

0.46

S&P 500 Autos

0.59

0.35

S&P 500 Services

0.47

0.22

S&P 500 Durables

0.42

0.18

S&P 500 Consumer Discretionary

0.72

0.52

Source: Bureau of Economic Analysis, Thomson Reuters from 1/31/1995 through 6/30/2009.

spending, non-durable goods spending is nonetheless economically sensitive and has a big impact on Consumer Discretionary performance. For instance, when the economy is strong, consumers are more likely to purchase more expensive food and apparel. Table 3.2 shows the relationship between non-durable goods spending and Consumer Discretionary industry group performance over the last 15 years. Non-durable goods are primarily sold by Retailers, which represent about 36 percent of the S&P 500 Consumer Discretionary Index. As such, the correlation between changes in non-durable goods spending and Retail industry group performance is 0.70 with an R-squared of 0.49. Since Retail is the largest industry group in the S&P 500 Consumer Discretionary Index and the conditions underlying strong non-durable goods spending also benefit the rest of the sector, the correlation between non-durable goods spending and Consumer Discretionary sector performance is understandably strong. Services The US economy is service-based—60 percent of consu-

mer spending is on services like visits to the doctor, college tuition, interest payments on household debt, restaurant bills, and vacations. The Consumer Discretionary sector is not—only about 14 percent of the sector earns income by providing services. The relationship between spending on services and Consumer Discretionary industry group performance is not as strong as durable and non-durable goods

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Table 3.3 Spending on Services and Consumer Discretionary Industry Group Performance Industry Group

Correlation

R-Square

S&P 500 Media

0.74

0.55

S&P 500 Retailing

0.60

0.36

S&P 500 Autos

0.55

0.30

S&P 500 Services

0.25

0.06

S&P 500 Durables

0.17

0.03

S&P 500 Consumer Discretionary

0.65

0.43

Source: Bureau of Economic Analysis, Thomson Reuters from 1/31/1995 through 6/30/2009.

because economically insensitive things—e.g., medical expenses, tuition, and mortgage interest—are the largest pieces of services spending. Table 3.3 shows the relationship between spending on services and Consumer Discretionary industry group performance over the last 15 years. Though the correlation between services spending and the overall sector is still a strong 0.65, it’s the weakest correlation of the three types of spending. Services spending has a fairly weak correlation because only about 20 percent of the sector is comprised of service companies, and the majority of spending on services is directed at economically inelastic factors like interest on debt, medical bills, and college tuition. Income and Employment

Consumer spending is a vital Consumer Discretionary driver, but what drives consumer spending? Disposable income, first and foremost. Disposable income represents a household’s income after taxes and payments to programs like Social Security and Medicare. Disposable income is what consumers use to fuel spending—on both staples and discretionary goods. The link between disposable income and consumer spending is very clear. Table 3.4 shows the correlation between year-over-year changes in disposable income and different categories of consumer spending over the last 15 years. Overall, the correlation is a very strong

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Table 3.4 Disposable Income and Consumer Spending Disposable Income Consumer Spending

Correlation

R-Square

Services

0.71

0.51

Non-Durables

0.62

0.38

Durables

0.49

0.24

Total

0.67

0.45

Source: Bureau of Economic Analysis from 1/31/1995 to 6/30/2009.

0.67. Again, the correlation between growth in disposable income and durable spending is weaker because spending on durable goods is also influenced by interest rates and consumer sentiment. Wage Growth and Disposable Income Disposable income is

clearly an important driver for consumer spending and, therefore, Consumer Discretionary stocks. Wages are the most significant driver of disposable income growth. Figure 3.5 shows the relationship between 10.0%

10.0%

8.0%

8.0% 6.0%

US Disposable Income

4.0% 4.0% 2.0% 2.0% 0.0% 0.0%

⫺2.0%

⫺2.0%

⫺4.0%

Figure 3.5

2008

2007

2006

2005

2004

2003

2002

2001

2000

1999

1998

1997

1996

Year-Over-Year Changes in US Disposable Income Year-Over-Year Changes in US Wages and Salaries 1995

⫺4.0%

US Wages and Salaries

6.0%

⫺6.0%

Wages and Disposable Income

Source: Bureau of Labor Statistics, Bureau of Economic Analysis as of 6/30/2009.

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wages and disposable income over the last 15 years. With an R-squared of 0.57, the relationship is closely linked. Employment Naturally, strong employment sets the stage for

widespread wage growth. The simplest measure of employment is the Bureau of Labor Statistics’ (BLS) monthly Non-Farm Payrolls report, which estimates the total number of people employed outside the highly volatile farming segment. Growing employment not only expands the number of consumers able to buy discretionary goods, but it also exerts upward pressure on wages, as shown in Figure 3.6. Indeed, over the last 15 years, the correlation between year-over-year changes in Non-Farm Payrolls and Wages is 0.96 with an R-squared of 0.91.2 But many investors make a common mistake, particularly at the end of a recession. Stocks trade on future expectations—they don’t confirm the present or what just happened. As recessions near the end,

4.0%

10.0%

3.0%

8.0% 6.0%

1.0% 4.0% 0.0% 2.0% ⫺1.0% 0.0%

⫺2.0%

⫺2.0%

⫺3.0% ⫺4.0%

⫺4.0%

Figure 3.6

2008

2007

2006

2005

2004

2003

2002

2001

2000

1999

1998

1997

1996

Year-Over-Year Changes in US Non-Farm Payrolls Year-Over-Year Changes in US Wages and Salaries 1995

⫺5.0%

US Wages and Salaries

US Non-Farm Payrolls

2.0%

⫺6.0%

Employment and Wage Growth

Source: Bureau of Labor Statistics, as of 6/30/2009.

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Employment Is a Lagging Indicator of Economic Growth As recessions end and a new economic cycle of growth begins, it’s typical to hear headlines complaining about a “jobless recovery.” We heard that in 2009 and following the 2001 recession. A perennial economic argument is whether employment drives economic growth, or if economic growth drives employment. Certainly, strong employment is good for the economy, and vice versa. But what comes first? Decidedly, economic growth comes first. Figure 3.7 shows changes in employment clearly lag changes in economic growth. It may seem counterintuitive at first, but actually makes perfect sense. When the economy begins to weaken, employers will wait until they have direct evidence of a downturn before making the expensive decision to layoff workers. Similarly, when the economy begins to rebound, employers are cautious about rehiring until economic growth is unmistakable. Look at it this way, if you are the CEO of a firm, when do you ramp up hiring? Before your sales rebound, or after? Rationally, you’d wait until after you have a rebound in sales—and that’s what’s reflected in Figure 3.7.

4.0%

6.0%

3.0% 4.0%

1.0%

2.0%

0.0% 0.0% ⫺1.0% ⫺2.0%

⫺2.0%

⫺3.0%

⫺4.0%

1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008

Year-Over-Year Changes in US Gross Domestic Product Year-Over-Year Changes in US Non-Farm Payrolls ⫺6.0%

US Non-Farm Payrolls

Gross Domestic Product

2.0%

Figure 3.7

⫺4.0% ⫺5.0%

Gross Domestic Product and Employment

Source: Bureau of Labor Statistics, Bureau of Economic Analysis as of 6/30/2009.

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Consumer Discretionary stocks frequently price in the coming recovery and rise in anticipation of later, better news. So while employment is an important driver of Consumer Discretionary profits, it can be the anticipation of improving employment conditions that drives stock prices higher. Economic Growth

Economic growth is another important driver for Consumer Discretionary stocks, as it is for any sector with elastic demand. Economic growth typically translates into the strong employment and wage growth necessary to goad increases in consumer spending that translate into growing profits for Discretionary firms. But remember, stocks price in future expectations, not current conditions. This is why the stock market is said to be a leading economic indicator and unemployment a lagging indicator. As with employment data, this is particularly important to watch as recessions end. It’s perfectly normal for stock prices of economically sensitive companies to start rising before the recovery begins, and certainly well before the recovery shows up in official data, since official data are released on a lag. Investors who wait for confirmation from official economic data can make a costly mistake. Interest Rates

Interest rates are another important Consumer Discretionary economic driver because they signal borrowing costs for corporations and individuals. Remember, the majority of Consumer Discretionary companies produce or sell durable goods and other big-ticket items (like cars), and these goods often require financing. If interest rates are high, borrowing is more expensive, limiting consumer demand. Interest rates generally fall into two categories: central bank target rates and marketdetermined rates. Central bank target rates are used by central banks (like the Federal Reserve, or “Fed”) as a monetary policy tool. By raising or lowering rates, the Fed helps moderate inflation, keeps the economy

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growing, encourages employment, and can achieve other policy ends. All other interest rates—like those on Treasury bonds, fixed and floating rate mortgages, and other debt securities—are set by the market. These interest rates can and do move independently of central bank rates and are indicative of an entity or individual’s borrowing costs. In the US, the Fed’s monthly interest rate statement is important for two reasons. First, it sets a broad baseline for borrowing costs. For instance, over the last 15 years, the fed funds target rate and the average interest rate on a 30-year fixed mortgage show a 0.79 correlation and 0.63 R-squared. Second, it provides the market an intra-quarter glimpse into bank borrowing costs. All else being equal, more benign interest rates make it easier for consumers to buy large-ticket items and easier for firms to profit on assets purchased with borrowed funds. When borrowing costs are high, capital-intensive firms like Ford or Whirlpool may see higher costs as debt becomes more expensive. Similarly, purchases of durable goods requiring financing become more expensive, limiting demand. However, it is important to take into account the broader economy when considering interest rates. For example, if a company’s cost of borrowing is 10 percent, but the return it earns using the borrowed funds is 15 percent, then a “high” interest rate is not necessarily bad—the return on assets purchased with the borrowed money justifies the cost. Similarly, if it costs a consumer 12 percent to finance a car purchase but personal wages and income are growing 16 percent, the interest rate isn’t nearly as onerous as it may seem. Currency

Understanding the role of currency as a driver of Consumer Discretionary stock performance can nuance your analysis. Whirlpool, the world’s largest appliance maker, earns about 43 percent of its revenue outside of North America.3 When it sells a washing machine in Europe, it must convert the foreign currency revenue into US dollars for reporting purposes (whether the revenue is actually repatriated is another topic entirely—for the purposes of this example, we’ll keep it simple). Let’s say Whirlpool decides to sell

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washing machines for €500 in the first quarter. The current exchange rate is $1/€2, so, in dollar terms, Whirlpool grosses $250 (€500/€2 ⫽ $250) for every washer it sells in Europe. What happens if the euro appreciates over the quarter, and now $1 will only buy €1.5? That same €500 would now be worth $285.71 (€500/€1.75 ⫽ $285.71). Although Whirlpool could alter prices in response to short-term changes in exchange rates, most manufacturers change prices just a few times a year. Currency can thus impact earnings profoundly, and stronger earnings are ultimately good for stock prices. Additionally, currency can affect stock values. Stocks in your portfolio are no different from Whirlpool’s washing machines, except the underlying value of the stock can change on a daily basis independent of currency (Whirlpool can change the price of its washing machines too, but rarely does this happen on a daily basis). While investors needn’t perfect a currency forecast to choose a suitable investment, understanding a firm’s currency exposure adds another layer of analysis. POLITICAL DRIVERS What happens in Washington can influence what happens on Wall Street—always been that way, probably always will. So it’s worthwhile to focus energy on understanding the more significant political drivers most relevant to the Consumer Discretionary sector, including: • • • •

Taxes Trade policy Regulation Economic liberalization

Taxes

Tax policy can be both a macro and a micro driver for the stock market. For example, higher taxes generally lead to less spending. But on a smaller scale, if taxes materially increase on hamburgers, people may eat fewer hamburgers and switch to alternatives, like fish tacos—bad

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for hamburgers, good for fish tacos. So while taxes are an important driver of overall economic activity, they can also play a role in determining specific industry and even firm performance. Income Taxes We can look at the aggregate effects taxes have on the economy through several lenses. Since higher levels of disposable income normally translated to higher consumer spending historically, and higher consumption is positively correlated to Consumer Discretionary relative performance, it is important to take note of significant changes to income tax policy. At the same time, aggregate taxes only represent about 12 percent of total personal income,4 meaning other factors like wages and dividends can be more meaningful to your analysis. Sales Tax The second major tax driver is sales tax—a point-of-sale

tax on consumption. When countries or states increase sales tax, consumer spending is inevitably affected. In many regions, including Europe, a value-added tax (VAT) system is prevalent. This VAT is different from sales tax—a sales tax is a flat rate based on the sale price of goods, whereas the VAT is determined by the total value added to goods at each level of the supply chain. The last important tax-related driver for Consumer Discretionary stocks are industry-specific taxes. Legislators have been known to target select industries in an attempt to deter consumption of products deemed moral or environmental hazards, like gambling, cigarettes, and fuel consumption. For example, casinos pay additional taxes—in some cases, very significant taxes—to operate gambling establishments. In Delaware, 52 percent of racetrack gambling revenue (most taxes are levied on profits, not revenue) goes to the state general fund.5 Gambling taxes in Nevada are among the lowest in the US, maxing out at 7.75 percent of gross gaming.6 It is no coincidence Nevada’s low taxes support the nation’s largest gaming area. Industry-Specific Taxes

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Separately, in the US, new cars with gas mileage ratings less than 22.5 miles per gallon (mpg) are subject to the Gas Guzzler Tax. Excluding minivans, sport utility vehicles, and pick-up trucks, the 1978’s National Energy Act imposed the tax to discourage purchases of fuel-inefficient vehicles. By the early 1980s, fuel-efficient alternatives were becoming more and more common—Ford even made a fourcylinder Mustang! It is more than just coincidence that Japanese imports became much more competitive over the same period. Trade Policy

Free trade is a vital component of globalization, allowing goods and capital to flow efficiently across borders. Trade policy can impact all Consumer Discretionary firms that import and/or export goods. When the protectionist wind blows, governments may be inclined to increase subsidies for their domestic producers, impose tariffs on imported goods, or sometimes enact a combination of the two—subsidies and tariffs distort the natural pricing mechanism of a free market, frequently resulting in higher prices for consumers. Conversely, opening new trade corridors can allow firms access to more sales channels and/ or more competitively priced vendors.

Drivers at Work: Japan’s “Voluntary Export Restraint” One example of trade policy impacting the competitive landscape in the US happened in 1981. Suffering from the combination of a recession, rising gas prices, shifting demand toward smaller, more fuel-efficient cars, and competition from Japanese imports, the US auto industry was on the brink of bankruptcy. Determined not to break a campaign trail promise, President Ronald Reagan refused to implement a tariff on Japanese imports. His administration successfully negotiated a voluntary export restraint with the Japanese government, whereby Japanese automobile exports would be capped at 1.68 million units per year, roughly the mid-point of shipments between 1979 and 1980. (Continued)

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The restriction was a major victory for the US auto industry, right? Wrong. Instead, Japanese manufacturers profited and did little to improve US competitiveness. To offset lower production, the Japanese simply raised prices. Additionally, realizing it made little sense to produce small, low-margin cars if volume would be capped, Japanese producers reinvested their profits into engineering larger, margin-friendly vehicles. This success permanently secured their competitive position in the automotive landscape. Indeed, from 1981 until 1994 (when the export restraint was lifted) Japanese automakers returned an annualized 12.0 percent versus 10.6 percent for their American counterparts.* While using trade policy to forecast stock-specific performance can be difficult and we generally avoid it, it might be useful in sub-asset allocation decisions. Specifically, are subsidies limiting innovation and competition? What is the risk to a given industry if quotas (voluntary or otherwise) or tariffs are imposed? Is the long-term potential of this stock or sector diminished, improved, or the same if trade barriers or subsidies are eliminated? * Thomson Reuters.

Regulation

In addition to tariffs and quotas, investors should be on the lookout for strong political lobbies or even outright government takeovers. One of the clearest examples of regulation altering the US automotive competitive landscape is the late 1970s introduction of the “two-fleet rule.” Part of the corporate average fuel economy standards (CAFE) in 1975, the two-fleet rule states an automaker must divide its vehicles into two fleets, domestic and foreign. Each fleet must average 27.5 miles per gallon (mpg). Realizing a single-fleet rule would prompt automakers to outsource small car production to low-cost manufacturing sites (which, not coincidentally, are where the most small cars are sold), the UAW successfully lobbied the government to implement the rule and save domestic jobs. But the rule puts US automakers at a disadvantage since small cars have slimmer profit margins and require cheap manufacturing not often found in the US. Forcing the automakers to build low-margin

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automobiles in an expensive market is not only unprofitable, it also keeps those workers from finding more productive, value-creating jobs. It’s not all that different than if the government were to say the automakers need to build horse-drawn carriages to protect those jobs, even if there’s no demand for such an archaic product! One of the major reasons General Motors and Chrysler were so unprofitable was their inability to exit loss-making small car production due to the two-fleet rule. As demand for trucks and SUVs weakened, so too did the US auto industry, resulting in the eventual bankruptcy and government takeover of the two companies. Economic Liberalization

Many economies, particularly those in emerging markets, are handcuffed by centuries of ineffective and inconsistent leadership. Misguided policies directed at enriching a leader’s family and friends or at stimulating a single sector can often detract from sound economic policy. At first, these sound economic policies may be unpopular, but as per capita income and GDP grow, previously fledgling economies can rapidly transform into global economic powerhouses. As Fisher Investments on Emerging Markets discusses at length, Brazil is a good example. Brazil’s last two Presidents—Fernando Cardoso and Luiz Inácio Lula da Silva (Lula)—have made South America’s largest economy a good example of how political reform can help drive a dramatic economic expansion. Overhauling the national pension system reduced Brazil’s historic deficit spending, limiting inflation and allowing the central bank to significantly reduce interest rates. Lower rates helped fuel the country’s growing securitization market, providing tremendous growth in credit issuance, as Figure 3.8 depicts.7 Other programs, including providing home loans to low-income households and tax breaks on a variety of construction materials and appliances, in addition to investments in its domestic infrastructure and major industries, have resulted in annualized GDP growth of 4.1 percent since Lula took office in 2003.8

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Fisher Investments on Consumer Discretionary 500,000 Private Sector Credit

Private Sector Credit (Millions of R$)

450,000 400,000 350,000 300,000 250,000 200,000 150,000 100,000 50,000

Figure 3.8

2009

2008

2008

2007

2007

2006

2006

2005

2005

2004

2004

2003

2003

2002

2002

2001

2001

2000

2000

1999

1999

1998

⫺

Brazilian Private Sector Credit

Source: Thomson Reuters, as of 6/30/2009.

SENTIMENT DRIVERS Sentiment is the most intangible stock market driver. At its core, sentiment represents people’s collective mood. It can play a large role in stock market behavior because the stock market is driven by human beings making decisions—inclusive of their rationalities and irrationalities. While we recognize the importance of consumer’s moods and attitudes, we’re more interested in forecasting how they’ll feel tomorrow or a few months from now. Sentiment surveys are inherently based on today’s feelings, even if they ask questions about the future. And since the surveys are compiled and published at a later date, they are inherently backward-looking (or at best coincident) and only reflect where sentiment has been, not where it is going. This minimizes the usefulness of the various sentiment indexes when making investment decisions. However, judging the preference for elastic and inelastic demand, as well as gauging to what degree a company is adjusting its

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product mix and marketing to capture consumer trends, can add an extra layer to your analysis. For the Consumer Discretionary sector, the most important forms of sentiment are: • Elastic/Inelastic investment preference • Consumer tastes Elastic/Inelastic Investment Preference

Understanding whether sentiment is likely to favor price- and incomeelastic or inelastic firms is a key variable in assessing the Consumer Discretionary weighting in your portfolio. When investor sentiment is bullish, investors traditionally place a premium on price- and incomeelastic firms deemed likely to see strong demand dependent on brisk economic activity. During such periods, Consumer Discretionary stocks typically see an expansion in their relative valuation multiples. Conversely, when investor sentiment becomes bearish, investors often place a premium on price- and income-inelastic companies deemed likely to see consistent demand independent of a deteriorating economic environment. Either way, the increase or decrease in relative valuation is largely the result of a sentiment shift. Consumer Tastes

Consumer preferences can be confounding to track; however, they are a powerful driver of company-specific performance. Fine-tuning a marketing pitch or adjusting production to capture a hot trend can translate into rich profits for companies that get it right—and disaster for those that don’t. For example, in the early 2000s, designer jeans were all the rage and True Religion (a designer jeans manufacturer) benefited immensely. Instead of marketing the durability of the jeans or the quality of the design, the company relied on exclusive distribution and high prices to capitalize on consumers’ demand for high fashion. Crocs on the other hand, a footwear producer, ran into trouble after failing to diversify its

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core sandals business. As trends turned against it, the company nearly went bankrupt before diversifying its product line. Investing to capture short-term trends can be risky, but investors who get it right are often rewarded with rich returns.

Chapter Recap The Consumer Discretionary sector has a multitude of drivers that dictate both operational and stock market performance. These drivers can be grouped into three categories: economic, political, and sentiment. • Consumer spending (PCE) is the most important driver of Consumer Discretionary performance. PCE, in turn, is driven by trends in employment, wages, and disposable income. • Interest rates affect the cost of capital for Consumer Discretionary firms and impact consumer behavior. • Currency can affect operational and stock price performance, so understanding a company’s currency exposure is important. • Political drivers like taxes, trade policy, and regulation also influence the Consumer Discretionary sector. • Sentiment, whether in the form of consumer trends or investor preference for elasticity, can have a dramatic impact on returns.

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II NEXT STEPS: CONSUMER DISCRETIONARY DETAILS

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4 CONSUMER DISCRETIONARY SECTOR LANDSCAPE

N

ow you’ve got the basics of how the Consumer Discretionary sector works, an understanding of its history, and its high-level drivers. Just like the economy, sectors are made of many distinct parts—some relatively similar to others and some quite unique. To better understand the whole, you must understand the parts. Chapter 1 covered the basic types of the Consumer Discretionary sector’s stocks: Media, Retailing, Automobiles & Components, Consumer Durables & Apparel, and Consumer Services. But within those classifications, there are numerous types of firms with very different product lines, end markets, and drivers. While an understanding of every company isn’t necessary, a firm grasp on the major industries is vital before making any sector-related portfolio decisions. This chapter explores the sector’s industries and how an investor can begin forming opinions on each.

59

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GLOBAL INDUSTRY CLASSIFICATION STANDARD (GICS) Before beginning, some definitions: The Global Industry Classification Standard (GICS) is a widely accepted framework for classifying companies into groups based on similarities. The GICS structure consists of 10 sectors, 24 industry groups, 68 industries, and 154 sub-industries. This structure offers four levels of hierarchy, ranging from the most general sector to the most specialized sub-industry: • • • •

Sector Industry group Industry Sub-industry

Let’s start by breaking down the Consumer Discretionary sector into its different components. According to GICS, the Consumer Discretionary sector consists of 5 industry groups, 12 industries, and 36 sub-industries. Following are the industry groups and corresponding industries for the sector. Industry Group: Automobiles & Components

• Automobiles • Auto Components Industry Group: Retailing

• • • •

Specialty Retail Multiline Retail Internet & Catalogue Retail Distributors

Industry Group: Media

• Movies & Entertainment • Cable & Satellite • Publishing, Broadcasting & Advertising

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Industry Group: Consumer Durables & Apparel

• Household Durables • Textiles, Apparel & Luxury Goods • Leisure Equipment & Products Industry Group: Consumer Services

• • • •

Restaurants Hotels, Resorts & Cruise Lines Casinos, Gaming & Leisure Facilities Diversified Consumer Services

GLOBAL CONSUMER DISCRETIONARY BENCHMARKS What’s a benchmark? What does it do, and why is it necessary? A benchmark is your guide for building a stock portfolio. You can use any well-constructed index as a benchmark—examples are in Table 4.1. By studying a benchmark’s makeup, investors can assign expected risk and return to make underweight and overweight decisions for each industry. This is just as true for a sector as it is for the broader stock market, and there are many potential Consumer Discretionary sector benchmarks to choose from. (Benchmarks will be further explored with the top-down method in Chapter 7.) Differences in Benchmarks

What does the Consumer Discretionary investment universe look like? It depends on the benchmark, so choose carefully. The US Consumer Discretionary sector looks very different from that of Europe, Japan, and emerging markets (EM). Table 4.1 shows major domestic and international benchmark indexes and the percentage weight of each sector. Sector weights show each sector’s relative importance in driving overall index performance. For example, while the Consumer Discretionary sector represents 13 percent of the Russell 2000, it is just 5 percent of the MSCI EM Index. Since many emerging markets

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7.6% 5.3% 4.9%

Materials

Tele communication Services

Utilities

Source: Thomson Reuters, MSCI, Inc.1 as of 6/30/2009.

100.0%

11.8%

Information Technology

Total

9.9%

20.2%

Financials

Industrials

12.0%

Energy 9.7%

9.8%

Consumer Staples

Health Care

8.8%

Consumer Discretionary

Sector

MSCI All Country World (Total World)

100.0%

5.0%

4.6%

6.8%

11.7%

10.3%

10.7%

19.7%

11.4%

10.5%

9.3%

MSCI World (Developed World)

Table 4.1 Benchmark Differences

100.0%

6.4%

6.0%

9.4%

5.2%

11.3%

8.4%

24.6%

8.7%

10.0%

10.0%

100.0%

4.1%

3.5%

3.2%

18.3%

9.9%

14.0%

13.6%

12.4%

12.0%

9.0%

MSCI EAFE (Developed World S&P 500 Ex-US) (Large Cap US)

100.0%

3.6%

1.3%

3.8%

19.8%

15.9%

15.2%

19.4%

4.5%

3.5%

13.0%

Russell 2000 (Small Cap US)

100.0%

3.9%

10.5%

13.5%

12.3%

7.2%

2.5%

24.1%

15.9%

5.1%

5.0%

MSCI Emerging Markets (Emerging Markets)

Consumer Discretionary Sector Landscape

63

economies have yet to build a robust middle class, consumer-related companies are understandably smaller than resource- or industrialfocused segments. The large Consumer Discretionary weight in the Russell 2000 is also due to the nature of the index itself. As a small cap index, Energy and Consumer Staples firms are relatively underrepresented because firms in these sectors often rely on size to generate economies of scale. The remaining eight sectors end up looking especially large relative to the other indexes. Understanding these differences in benchmark weights is key to building a balanced, risk managed portfolio. Wide sector weight deviations can also occur from country to country, as shown in Table 4.2, which includes selected countries from the MSCI All Country World Index. US firms clearly have the most influence on the sector—over double the size of Japan, who has the next largest representation. Table 4.2 MSCI ACWI Consumer Discretionary Index Weights by Country Country

Weight

US

44.6%

Japan

22.0%

France

6.5%

Germany

5.6%

UK

5.2%

Korea

1.9%

Sweden

1.8%

Canada

1.5%

South Africa

1.0%

China

1.0%

Hong Kong

1.0%

Switzerland

1.0%

Italy

0.9%

Rest of the World

6.0% 2

Source: Thomson Reuters, MSCI, Inc. as of 6/30/2009.

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0.4%

4.8% 24.4% 14.4% 6.3% 2.8% 1.0% 22.3% 15.6% 7.7% 6.3% 1.5% 13.1% 11.6% 1.5%

Auto Components

Retailing

Specialty Retail

Multiline Retail

Internet & Catalogue Retail

Distributors

Media

Consumer Durables & Apparel

Household Durables

Textiles, Apparel & Luxury Goods

Leisure Equipment & Products

Consumer Services

Hotels, Restaurants & Leisure

Source: Thomson Reuters, MSCI, Inc.3 as of 6/30/2009.

Diversified Consumer Services

7.6%

19.7%

Automobiles

8.0%

2.1%

8.2%

10.7%

21.0%

14.6%

1.0%

1.1%

3.7%

8.2%

14.0%

6.4%

36.0%

42.4%

24.6%

Automobiles & Components

EAFE

ACWI

Industry Group/Industry

8.2%

0.0%

8.2%

0.4%

5.0%

15.2%

20.6%

18.8%

3.0%

0.9%

8.3%

9.6%

21.9%

7.1%

23.4%

30.5%

EM

1.6%

11.9%

13.5%

1.6%

6.4%

7.2%

15.2%

22.5%

0.8%

2.9%

6.1%

14.7%

24.6%

4.7%

19.5%

24.1%

World

Table 4.3 Consumer Discretionary Industry Group and Industry Weights

2.3%

17.3%

19.6%

1.3%

5.1%

4.0%

10.4%

28.8%

0.7%

4.2%

9.2%

21.7%

35.8%

2.2%

3.2%

5.4%

S&P500

10.3%

20.6%

30.9%

4.8%

15.2%

8.3%

28.3%

6.6%

0.3%

3.1%

2.4%

23.8%

29.6%

4.3%

0.2%

4.5%

Russell 2000

Consumer Discretionary Sector Landscape

65

Industry Weights

Not only can sector weights vary, but so can industry weights—sometimes greatly, depending on the chosen benchmark. Table 4.3 shows the weight of each Consumer Discretionary industry group and industry within each benchmark. Understanding these weights allows you to not only make better decisions about relative weights of various industries, but also focus on the most important components. For Consumer Discretionary, Automobiles & Components, Retailing, and Media make up the majority of the weight in most benchmarks and are therefore the focus of much of this chapter. Concentrating on Bellwethers

Drilling down one more layer, it’s important to understand the makeup of each industry at the stock level. Some industries are more concentrated than others—in other words, one or two large stocks may make up the majority of an industry. When an industry is particularly concentrated, understanding what drives the largest stocks—the bellwethers—is key. Table 4.4 highlights industry concentration in the MSCI ACWI. The “Industry” column represents the top five stocks (by market cap) as a percent of the overall industry. The higher the concentration, the more important it is to understand industry bellwethers. Industry concentration is the result of many factors, including the importance of economies of scale, barriers to entry, and industry depth, among others. Automobiles, for example, is a highly concentrated industry. As a manufacturing-focused business, it is in the best interest of an automobile manufacturer to be large enough to capitalize on economies of scale. Conversely, the Hotels, Restaurants & Leisure industry is more fragmented due to minimal barriers to entry (e.g., it takes much less capital to open a restaurant than to start a car-manufacturing firm). Diversified Consumer Services (which includes companies like tax preparer H&R Block and hair salon operator Regis Corp.), Distributors, and Leisure Equipment & Products are highly concentrated because

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Table 4.4 Industry Concentration Ratios Industry Diversified Consumer Services

Top 5 Stocks 100.0%

Distributors

94.6%

Internet & Catalogue Retail

90.2%

Leisure Equipment & Products

73.8%

Automobiles

66.0%

Textiles, Apparel & Luxury Goods

57.8%

Auto Components

57.2%

Household Durables

56.4%

Multiline Retail

54.9%

Hotels, Restaurants & Leisure

54.2%

Source: Thomson Reuters, MSCI, Inc.4 as of 6/30/2009.

there simply aren’t that many publicly traded hair salons or tax preparers out there. Indeed, there are only six Distributors in the MSCI ACWI Consumer Discretionary Index, and just five Diversified Consumer Services companies! Understanding the composition of and differences in benchmarks and industries is the first step to building a diversified portfolio. Now, let’s flesh out your understanding of each of the industry groups, starting with the largest—Automobiles & Components. AUTOMOBILES & COMPONENTS INDUSTRY GROUP The Automobiles & Components industry group breaks down into the following industries: • Automobiles • Auto components Automobiles

This industry includes firms engaged in the design, manufacture, and sale of automobiles and motorcycles. The industry is characterized by:

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• Economic sensitivity • Significant barriers to entry • Heavy governmental regulation It’s also the largest industry in the Consumer Discretionary sector. Economically Sensitive Cyclical Demand In 2008, over 65 million

cars were sold globally. The US is the largest market for automobiles, representing about 20 percent of global sales. China is the second largest at 13 percent, while other major economies like Japan, Germany, and the UK make up smaller portions at 7.6 percent, 4.7 percent, and 3.2 percent, respectively. As a durable good, demand for automobiles is impacted by economic factors like wages and disposable income, in addition to sentiment and government regulation (more on that later). Interest rates are another key consideration since most cars are financed. Periods of steady economic growth are typically good for car sales. We purposely say “steady” rather than “positive” because economic growth may be volatile and even quite strong at turning points in the economy. Consumers may wait for several quarters of positive economic growth to make a commitment like buying a car or restrict purchases if they suspect the economy may weaken. Indeed, even though disposable income grew during much of the 2008 to 2009 bear market, automobile sales fell sharply as economic deterioration and acute consumer uncertainty contributed to declining durable goods spending. Conversely, the relative economic stability of the 1990s drove a golden decade for the US automobile industry, with unit volumes growing 9 out of 10 years despite the market being nearly 100 percent saturated. Demand cyclicality is also impacted by the replacement cycle. During periods of weak economic growth, consumers may delay purchases of new cars. However, this is not a long-term solution. As the fleet of operating automobiles ages, consumers must invest to replace cars that can’t be repaired. While the exact number is difficult to forecast, the replacement cycle is responsible for about 10 million car sales in the US each year—a significant percentage of overall sales

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considering US auto sales fluctuated between 15 and 17 million units annually between 1998 and 2008.5 Significant Barriers to Entry Significant barriers to entry keep

established manufacturers in business and aspiring manufacturers on the sidelines. Manufacturing a single car is not profitable. Sometimes, manufacturing 10 million cars is not profitable. Manufacturing costs, high wages, raw materials expense, significant competition, and direct government ownership are just a few of the factors limiting new entrants in the automobile industry. High wage and benefit costs are most frequently associated with US automakers, where decades of prosperity and pressure from unions resulted in significant benefits to their employees. For example, the United Auto Workers (UAW), one of the nation’s largest unions, played a major role in increasing health care, pension, and pay benefits for its members. As a result, the hourly cost per employee at a General Motors plant is $81.18. Compare that to its Japanese competitors, where pay for comparable labor can be as low as $35 an hour.6 On top of sometimes hefty employee benefits, automobiles require significant investment in raw materials—an expensive and highly volatile proposition. In the US, raw materials represent less than 10 percent of the total cost of an average car, or about $1,600.7 That may not seem like a large number until it’s multiplied by the production volume of a leading car manufacturer. Honda, for example, produced 3.9 million vehicles in 2009.8 That equates to about $6.2 billion in spending on raw materials alone. In many industries, raw materials costs are pushed onto consumers through pricing. However, due to significant competition among the major automobile manufacturers, the ability to pass commodity inflation to consumers is limited. Heavy Government Regulation As we detailed in Chapter 3,

the government plays a significant role in auto operations. Whether enforcing arbitrary emissions standards or requiring certain cars be built in certain countries regardless of demand or costs, government intervention creates market disruptions by definition. Understanding

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the different labor, emissions, and export policies is important when analyzing automobile manufacturers. During the severe economic downturn in late 2008/early 2009, former industry heavyweights General Motors and Chrysler were nationalized through significant government investment. Some of the barriers to entry previously discussed in this chapter proved too onerous for these firms, with legacy benefit costs, significant operating deleverage, and raw materials inflation creating the perfect operational storm. Government intervention can disrupt a market, but direct government control subjects a company’s board of trustees to political considerations that can distract it from maximizing shareholder value. Additionally, it’s important not to analyze government regulation in a vacuum. For instance, even though the CAFE standards (see Chapter 3) are a US regulation, all global automobile manufacturers must comply or face fees on every car they sell in the US. In an increasingly global industry, this is key. Table 4.5 illustrates the degree to which the automobile industry has diversified. Note General Motors no longer has a market cap after being nationalized by the US government. Similarly, Chrysler is absent from the list since it was owned by private equity group Cerberus Capital until filing for bankruptcy in April 2009. Table 4.5 Top 10 Automobile Manufacturers Company

Country

Market Cap

2009 Revenue (USD)

Toyota Motor

Japan

$131,151

$204,234

Volkswagen

Germany

$ 99,751

$166,536

General Motors

US

N/A

$148,979

Ford Motor

US

$ 17,011

$146,277

Daimler

Germany

$ 38,364

$140,291

Honda Motor

Japan

$ 50,584

$ 99,594

Nissan Motor

Japan

$ 27,456

$ 83,933

BMW

Germany

$ 22,663

$ 77,843

Hyundai Motor

Korea

$ 12,812

$ 72,455

Suzuki Motor

Japan

$ 12,204

$ 29,893

Source: Thomson Reuters, Bloomberg Finance, L.P.

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Private companies are not required to report financial results to the public; however, Chrysler generated about $49 billion in revenue in 2007. Auto Components

The Auto Components industry includes automotive equipment manufacturers and tire producers. Auto Component firms fall into three categories: Tier One (T1)

• T1 producers sell assembly-ready components directly to automobile manufacturers. • Transmissions or fuel-injection systems are examples of T1 products. Tier Two (T2)

• T2 producers sell T1 producers the parts used in manufacturing finished goods for T1 components. • Gears, ball bearings, and cylinders are examples of T2 products. Tier Three (T3)

• Tier 3 producers sell T2 companies slightly modified raw materials for eventual machining. • For instance, a T3 manufacturer might sell pre-cut steel to a T2 manufacturer who will fashion the steel into a turbine for eventual use in a T1 turbo system. T1 suppliers have two distribution channels: original equipment manufacturers (OEMs) and the aftermarket. In the OEM channel, component manufacturers sell parts directly to auto manufacturers for use in production. The aftermarket includes sales of replacement parts to dealerships and other repair shops, as well as auto supply retailers like O’Reilly’s or Penske Automotive Group, for instance. Demand for OEM products results from various factors, including: • Production volume: This is the most straightforward source of demand for the OEMs. When global automobile production is rising, so too is demand for auto parts.

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• Production mix: Auto components for trucks and luxury automobiles carry higher margins than those for smaller, cheaper cars. When trucks and luxury cars are in favor, profit margins for component suppliers typically expand. • Technological content: Higher technological content requires more complex systems, and companies adept at systems integration command healthy profit margins. Aftermarket demand results from a different set of factors, including: • Used car supply: Used cars typically require more replacement parts than new ones. Since the supply of used cars rarely declines rapidly, demand in this channel is more reliable. • Used car age: As the fleet of used cars ages, demand for replacement parts grows. In periods of economic weakness, fleet age increases as consumers limit new car purchases. • Automotive modernization: With few exceptions, modern cars break down less than they used to. This is a marginal, long-term trend reducing demand for replacement parts. Automobile manufacturers are the largest portion of OEM demand for most auto component producers, while the aftermarket is most important for tire companies. The ratio of aftermarket to OEM demand for tire producers is about 5-to-1. For both types of companies, the aftermarket is more profitable compared to the automobile manufacturing industry, thanks to industry fragmentation. Converting Demand to Profit In addition to the demand drivers

mentioned here, key profit drivers in the industry include commodity trends, availability of supplies, and access to capital. Component producers try to pass input cost inflation to automobile manufacturers, limiting the impact of commodity inflation. However, when commodity inflation is severe, automobile manufacturers can use their immense bargaining power to push prices back on their supply chain. Because auto component companies are often smaller and less capitalized than

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automobile manufacturers, this can have a rapid and deleterious impact on profitability. The Auto Components industry is highly specialized. For instance, automobile manufacturers rely on just a handful of large battery suppliers that distribute globally. These suppliers in turn rely on smaller suppliers for lead and other battery components. The proliferation of just-in-time manufacturing means if any link in the supply chain is disrupted, the entire system is susceptible to an immediate halt until that link is restored. A cause of a supply chain disruption is lack of short-term financing to fund manufacturing and accounts receivable. When interest rates are high or rising, the automotive supply chain is less profitable and faces elevated risks of disruption. RETAILING INDUSTRY GROUP The Retailing industry group breaks down into the following industries: • • • •

Specialty Retail Multiline Retail Internet & Catalogue Retail Distributors

Familiar to most consumers, companies in the Retailing industry group sell discretionary goods to individuals. Whether from a store, catalogue, or website, a variety of managerial decisions influence retailer profitability—including merchandising, design, sourcing, location, and funding, among many others. Because Specialty and Multiline Retail comprise the majority of the industry group, most of this section will describe these industries. It will conclude with a review of common demand and profit drivers. Specialty Retail

Specialty Retailers emphasize product depth over breadth. These companies target a specific product category, be it books (Borders Group), auto parts (Pep Boys), home improvement (Home Depot), or electronics

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(Best Buy), and offer a deep assortment of goods. Deep product lines are targeted at a specific demographic, leveraging demand to broader macro economic trends as well as underlying demand for the specialized category. Low barriers to entry predicated on minimal fixed costs increase competition, while social trends and brand image can determine which retailers boom and which retailers bust. Multiline Retail

Multiline Retailers carry a wide assortment of product categories including apparel, home furnishings, jewelry, sporting goods, consumer electronics, and home appliances, among others. Some offer groceries too, but this section will focus primarily on retailers of discretionary goods since grocery stores are a part of the Consumer Staples sector. There are two types of Multiline Retailers: Departments Stores and General Merchandisers. Department stores supply a variety of goods and services through defined “departments” and cover a spectrum of demographics from low-end to high-end consumers. Characterized by large percentages of revenue generated from apparel, these companies often rely on a single floor replete with cosmetics, jewelry, and the most profitable apparel to drive store-level profitability and define the company’s image. Brand status is key for many department stores, requiring significant investments in location and in-store experiences. To offset these investments, department stores increase the initial mark up of their goods, an extra expense image-conscious shoppers are more than willing to incur. With few exceptions, department stores are located in enclosed malls. General merchandisers carry a similarly diverse product line, but limit overhead costs by housing all departments on one floor, with minimal separation between departments. Because these companies have lower operating costs, many compete on pricing rather than fashion content or image. With low pricing comes slim margins, meaning a focus on increasing the number of transactions (traffic) is more important than increasing product pricing. In addition to the traffic low prices generate on their own, major players like Target are adding

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groceries to their stores to capitalize on the convenience of consolidating all shopping at one location. Internet & Catalogue Retail

This diverse group of companies represents a fraction of the Consumer Discretionary sector. By replacing brick and mortar stores with catalogues or websites, these companies have even less overhead than a general merchandiser, but they must overcome two important factors to compete effectively. First, consumer aversion to purchasing goods sight-unseen via the Internet is a material concern and can be overcome through branding and pricing. Second, prices must be low enough that, even after paying for shipping, goods are still competitive with brick and mortar alternatives. Distributors

Distributors are middlemen. They may manage supply chains for an entire industry or for a single company. The largest publicly traded distributor in the world, Li & Fung, specializes in sourcing and delivering apparel and other soft goods to a variety of retail clients, including Wal-Mart. By taking the expense and capital requirements of inventory management out of the hands of their clients, Distributors play an important role in supply chain facilitation and management. Common Industry Characteristics

The economic drivers outlined in Chapter 3 underlying strong and weak spending environments are the key driver of Retailing profits. Strong spending drives growth in same store sales or comparable store sales (“comps”). But sales are only one piece of the puzzle. Location, merchandise, and inventory planning are other key considerations. Traffic, Price, and Mix Comps are the purest gauge of sales growth

because they exclude revenue gains from opening or acquiring new stores. In most cases, comps refer to sales growth at stores open at least a year. The major components of same store sales growth are

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traffic, pricing, and mix. Traffic is gauged by comparing the number of transactions in a given period versus the same period last year. Pricing is measured by comparing the price of similar goods sold this year versus last year. One way to calculate mix is to divide the average ticket by the average number of goods per ticket, minus any companyimplemented cost increases or decreases. For instance, if traffic increased 6 percent, pricing decreased 3 percent, and mix increased 5 percent, comps would be up 8 percent. Location, Location, Location Determining a target market and its

associated demographics are the most important factors in choosing a location. Rent expense and other considerations are also important. Let’s use home improvement retailer Lowe’s as an example. Demand for Lowe’s goods is primarily driven by new home construction, improvements, and repairs. As home improvement products are often fungible, easy substitution limits pricing power and pressures margins. Remember, low margins are often offset by maximizing volume and minimizing overhead. Given the above criteria, Lowe’s should look for a location with close proximity to existing and under-construction residential housing, low rent, and ample square footage. These locations are often found in suburban “Community Centers.” This kind of mall is open air, anchored by a few large-format specialty stores or general merchandisers, within about 5 miles of its target demographic, and located in a lowrent part of the community. Perfect for Lowe’s. The Right Stuff at the Right Time at the Right Price Another

key component for retailers is inventory and merchandise planning. Company management, design, and merchandise teams plan upcoming assortments and product lines based on extensive market research into the goods it predicts its target market will demand. Understanding style, social, and economic trends informs strategy across all retailers. Lead times vary by retailer, with apparel retailers requiring up to 6 to 12 months to design, plan, and order merchandise. Given this, emphasis should be placed on companies with a proven merchandising team.

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Once design and merchandise plans are set, management must determine how much inventory to order. Having too much inventory ties up cash and can lead to discounts or write-downs (reducing profitability), while having too little inventory can result in lost sales. Store growth, sales expectations, and cost of capital influence inventory decisions. Store growth is easiest to explain—if management is increasing its store count, inventory must increase by a similar amount. Sales expectations are predicated on economic forecasts and other companyspecific factors. If sales are expected to be weak, retailers will often try to reduce inventories by purchasing inventory at a slower pace than demand. Inventory is most often financed through cash flows or short-term debt. When short-term interest rates are increasing, inventories may be reduced as the potential return on invested capital falls because of higher cost of capital. Also, in difficult selling environments, retailers will often limit the amount of capital tied up in inventory to reduce the risk of loss or even insolvency.

MEDIA INDUSTRY GROUP The Media industry group breaks down into the following sub-industries: • Movies & Entertainment • Cable & Satellite • Publishing, Broadcasting & Advertising Media is one of the broadest industry groups. Its constituents include diversified multi-national entertainment companies like Walt Disney and Time Warner; regional cable & satellite broadcasters like British Sky Broadcasting and Comcast; advertising powerhouses like Omnicom, WPP Group, and Publicis Groupe; and multi-discipline publishers like McGraw-Hill or Pearson. Each sub-industry is unique, so this section will describe typical operations and common characteristics individually.

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Movies & Entertainment

Companies in this segment specialize in the production and distribution of three types of content: feature films, television, and music. In many cases, these companies are diversified conglomerates offering a range of related products and services, from branded video games to theme parks. Although barriers to entry are low, firms with scale have negotiating leverage over theaters and broadcast networks and can capitalize on vast cross-marketing opportunities. The Biz The three major types of content—feature films, television,

music—earn revenue in different ways and through different distribution channels. • Feature films: Major feature film studios and distributors like Warner Bros., Buena Vista, Twentieth Century Fox, and Paramount (among others) generate revenue by distributing feature films to theaters in return for upfront fees and a portion of ticket sales. Following the theatrical release, the movie is distributed on DVDs to retailers and rental services, as well as to pay-television broadcasters like HBO or Showtime—all for a fee based on box office success and viewership. Eventually, the distributor may license the film to a television network. • Television: Many film studios also own television production studios. Production studios sell programming to broadcasters for a fee and sometimes a portion of associated ad revenue. Most major production studios own broadcast networks, reducing programming costs and increasing ad revenue. First-run licenses are often exclusive but older shows may be syndicated—meaning the production studio grants numerous, non-exclusive licenses to broadcasters. To supplement advertising revenue, many studios sell DVDs or offer content online. • Music: Typically a smaller portion of overall revenue and profits for the major entertainment companies, recording companies were among the first to face industry-wide challenges like piracy and

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Table 4.6 MSCI ACWI Movies & Entertainment Sub-Industry Company Name

Market Cap ($, millions)

Country

Walt Disney

$ 43,318

US

Time Warner

$ 30,139

US

News Corp.

$ 24,979

US

Vivendi

$ 29,245

France

Viacom

$ 12,464

US

Toho

$ 3,085

Japan

Source: Thomson Reuters.

the shift toward digital distribution. They have yet to overcome these challenges. Recording companies arrange contracts with artists to produce albums. After paying the artist an up-front fee, the studio will recoup its production costs before paying trailers— a percentage of the album’s revenue. As we’ve alluded, the major Movies & Entertainment firms are large conglomerates with a variety of media and content businesses. Each has a different revenue and profit profile. Even though Disney, Time Warner, and News Corp. are part of the same sub-industry, each company has its own set of revenue and profit drivers you should investigate. Table 4.6 highlights the MSCI ACWI Movies & Entertainment Sub-Industry. Cable & Satellite

Cable & Satellite broadcasters distribute content via fiber-optic or direct broadcast satellite (DBS) connections and are also known as multichannel video programming distributors (MVPDs). These companies earn revenue from subscriber fees and advertising, offset by expenses paid to secure channel programming like ESPN or VH1. Characterized by significant barriers to entry, the emphasis of cash flows over profits, and strict government regulation, Cable & Satellite is unique because it is the only sub-industry in Media that does not generate the majority of revenue via content creation or advertising.

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An Elite Group Potent barriers to entry arise from the significant capital requirements involved in building fiber-optic networks or launching and maintaining geosynchronous satellites. In many countries, the government is the only organization with enough capital to build and maintain a network, which explains why there are so few publicly traded Cable & Satellite broadcasters outside the US. In the US, cable franchise rights give MVPDs the exclusive right to broadcast in a given region. Valued at the present value of estimated future cash flows of the region, plus additional fees, these rights are prohibitively expensive for all but the largest MVPDs. (Free) Cash (Flow) Is King Not only are cable franchise rights

expensive, they also provide MVPDs with near monopolies, regionally. The only thing keeping it from being a real monopoly is the presence of DBS providers, although certain municipalities enforce codes against installing satellite dishes. Monopolies limit both competition and growth in a given region. Additionally, government regulations (which we’ll cover in the next section) cap total market share. Since revenue and profit growth is limited, emphasis should be placed on how efficiently Cable & Satellite broadcasters convert net income to free cash flow. Free cash flow (FCF) is simply cash flow from operations less capital expenditures. In a sense, FCF is the corporate version of disposable income. Companies use this money to make acquisitions, pay dividends, buy back stock, or pay down debt. Robust net income and well-managed capital expenditures support strong FCF. However, if the company begins shirking capital expenditures to support FCF, it may find itself at a competitive disadvantage to competitors who invested in upgrading fiber-optic networks, for instance. Rules and Regulations Cable & Satellite broadcasters in the US are

subject to a variety of regulations implemented by the Communications Act of 1934 and Federal Communications Commission (FCC). In 2007, a 30 percent cap on national market share was implemented, limiting monopolistic practices and profit growth. Restrictions on pricing in markets deemed to be in the absence of “effective competition”

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limit revenue growth. The “must-carry” regulation forces MVPDs to carry local broadcasts for no charge. At first blush, the regulations may seem onerous. However, barriers to entry are so severe in Cable & Satellite broadcasting that managing monopolies is an important consumer protection. Publishing, Broadcasting & Advertising

The combined market capitalized weight of the Publishing, Broadcasting & Advertising sub-industries is less than the Cable & Satellite subindustry, which is in turn smaller than the Movies & Entertainment sub-industry. The three main types of publishing are newspapers, books, and magazines. Newspapers earn revenue by selling ad space and from circulation. Content can be purchased from news services like the Associated Press or Reuters or created in-house—often it’s a combination of both. Labor costs are typically high. Like newspapers, magazines set advertising rates based on the breadth of circulation and penetration rates. Both businesses are taking their content online, providing additional market penetration and revenue. Book publishers are more like a music studio than a newspaper or magazine—authors are paid an up-front fee and a percentage of sales or profits after the publisher recovers its costs. The majority of books are published for the consumer sector, although a portion goes to education. Revenue is earned via book sales.

Publishing

Broadcasting This segment includes radio and television broad-

casters. Radio broadcasters earn revenue by selling ad space, offset by expenses to either buy or create content for its target demographic. Television broadcasters like CBS, Grupo Televisa, Disney’s ABC, General Electric’s NBC, and News Corp.’s Fox earn revenue the same way. Advertising is sold in the up-front and spot markets. The up-front market lets advertisers lock in contracts before a show airs, while the spot market gives advertisers the flexibility of buying advertising space once a season is under way. Broadcasters in large markets are often owned by

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production studios, providing the production studio 100 percent of the advertising revenues rather than a fee for rebroadcasting its content. Advertising A rapidly evolving segment, advertisers earn revenue by creating and managing traditional and non-traditional advertising campaigns for a variety of organizations. Traditional advertising includes billboards, television commercials, newspaper ads, and mailers. Nontraditional advertising includes everything from internet pop-up ads and spam e-mail to guerilla marketing. Clients include corporations, political parties, armed forces, non-profit groups, and a host of other organizations. Rich compensation for top performers stems from competitive advantages built on creativity and foresight. Ad agencies are sensitive to economic growth since advertising budgets are often the first to be cut amid a downturn. The industry is dominated by a few large firms—client-preference favors companies with integrated capabilities like planning, buying, tracking, and public relations.

CONSUMER DURABLES & APPAREL INDUSTRY GROUP The Consumer Durables & Apparel industry group breaks down into the following sub-industries: • Household Durables • Textiles, Apparel & Luxury Goods • Leisure Equipment & Products Companies in the Consumer Durables industry group specialize in the manufacture and sale of products designed to last more than three years. Its constituents include consumer electronics manufacturers, homebuilders, and textile producers, among others. Often misjudged as economic bellwethers—particularly Homebuilders, a small sub-industry within Household Durables—the entire group represents just 1.2 percent of the MSCI ACWI Consumer Discretionary sector, and a nearly insignificant 0.1 percent of the broader index. Similarly, Leisure Equipment and Products, a sub-industry including companies that manufacture products like All Terrain Vehicles

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(ATVs) and other durable goods represent just 0.5 percent of the MSCI ACWI Consumer Discretionary sector and 0.05 percent of the broader index. Because these segments are nearly insignificant, this section will focus on the largest pieces of the Consumer Durables & Apparel industry group, namely Consumer Electronics (a sub-industry of the Household Durables industry), and Textiles, Apparel & Luxury Goods. Household Durables

Consumer Electronics represent the majority of the Household Durables industry. These companies develop, produce, and distribute televisions, audio and visual systems, mobile phone handsets, game consoles, and myriad other electronic products. Mostly located in Japan, consumer electronics firms are characterized by significant horizontal integration and potent barriers to entry. By Design It’s no accident Japanese firms represent 84 percent of the MSCI ACWI Consumer Electronics sub-industry. As described in Fisher Investments On Industrials, Japan surprised the world with its industriousness in the aftermath of World War II. Limited natural resources and a relatively small workforce resulted in pro-growth initiatives targeted at high value-add industries like consumer electronics. Tax shelters, import controls, and subsidized loans helped the fledgling industry grow, while the Toyota manufacturing process dramatically increased quality and efficiency. Soon, Japanese electronics companies came to dominate the global market, benefiting from overwhelming market share and economies of scale. Taking Diversification to the Extreme Modern consumer elec-

tronics firms are a highly diversified group. In addition to Japan’s economic support following World War II, the government encouraged the keiretsu system, whereby corporations grew into massive horizontally or vertically integrated conglomerates. The modern consumer electronics industry displays elements of horizontal and vertical integration.

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Panasonic, the world’s largest consumer electronics firm, builds televisions, microwaves, vacuum cleaners, computers, digital cameras, tools, exercise equipment, blood monitors, and batteries, displaying significant horizontal integration. Each of these products is built by a dedicated production company in which Panasonic typically owns a majority share. Horizontally disparate business lines benefit from the broad brand recognition—a customer who purchased a high-quality television may be more apt to buy a Panasonic computer over an unproven competitor. Also, internal control over manufacturing ensures product quality and minimizes supply risks. Broad integration has its risks, however. Horizontal integration leverages a company to a wide swath of consumer spending, exposing Panasonic to macroeconomic trends—particularly durable goods spending. Also, vertically integrated companies can be at a disadvantage to peers when input costs like commodities and labor are particularly low, increasing the affordability of outsourcing. In both cases, when demand weakens, profitability can quickly disappear as these firms rely on their ability to leverage their immense cost base. And Stay Out! As if overwhelming market share and horizontal

and vertical integration weren’t enough of a barrier to entry, consumer electronics companies require tremendous resources to remain profitable in an extremely competitive industry. Rich profits accompany well-received technologies, especially for the manufacturer that releases its product first. Heavy research and development (R&D) spending supports new product development. Over the last 20 years, the top three consumer electronics companies (Panasonic, Sony, and Sharp) have spent 6 percent of their annual revenue on R&D.9 Once a new product proves successful, imitators enter the market, pushing down prices. For instance, as LCD TVs grew in popularity in 2006 and manufacturers rushed into the industry, Sony reported prices on its Bravia LCD TVs fell between 25 and 30 percent.10 To offset price declines, manufacturers rely on significant production volume to create economies of scale. Costs associated with funding

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construction of manufacturing plants and working capital combine to keep all but the best-capitalized companies from competing. What About Homebuilders? Homebuilding and other small House-

hold Durables sub-industries like Household Appliances, Housewares & Specialties, and Home Furnishings represent a miniscule portion of the MSCI ACWI Consumer Discretionary Index, combining to make up 3 percent of the sector and 0.3 percent of the broader index. Due to the limited benefits of economies of scale and difficulties homogenizing home construction across various regions, homebuilders are often small- to mid-cap. Yet for most people, a home is the largest purchase they’ll ever make.

Housing Hysteria In 2007, homebuilders were benefiting from a boom in new home construction. Interest rates were low, and lending was challenging baseball as America’s great pastime. As delinquencies in sub-prime mortgages began to creep up and banks tightened lending in response, demand for homes fell, sparking a multi-year decline in prices. Media commentators assigned blame to homebuilders, saying irresponsible building led to a glut in inventories, pressuring prices and halting new construction. Though volatile, residential construction averages just 4 percent of GDP since 1929, and 4.4 percent at the peak of the housing “bubble” in 2007. Source: Bureau of Economic Analysis.

Textiles, Apparel & Luxury Goods

The Textiles, Apparel & Luxury Goods industry is a sort of hybrid— part retail, part manufacturing. Its unique characteristics are often overlooked. Textile and apparel manufacturers produce the clothes retailers stock their shelves with. Luxury goods producers manufacture and sell a variety of goods—from pens to purses, champagne to firearms—that are priced to exclude all but the wealthiest consumers. Both industries have unique demand drivers that deserve a careful look.

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Textiles and Apparel Textile and apparel manufacturers (like Nike, VF Corp., and Jones Apparel Group, to name a few) produce apparel and footwear. The majority of these companies use a multi-channel distribution strategy, relying on wholesale, retail, and e-commerce. In the wholesale channel, an apparel manufacturer sells its products to department stores and other specialty retailers. VF Corp., for instance, sells its North Face-branded apparel to multiline retailers like Nordstrom and specialty retailers like REI. North Face gear is also sold at VF Corp.-owned North Face retail stores as well as through its website. For some of its brands, VF Corp. operates outlet stores to clear out unsold or defective inventory. The multi-channel strategy provides textile and apparel manufacturers several benefits. Going back to the VF Corp. example, its retail stores allow it to set the brand’s image and test new products. Without these stores, VF Corp. would be reliant on department store clients to take the risk of buying untested new styles and set the brand’s image—both prospects carry risks for the department store and, thus, limit the prices VF Corp. can negotiate. Once a textile company has set its brand image and has a proven product to sell, it can rely on department stores for large orders. However, with larger orders come slimmer margins, so controlling manufacturing, logistics, and central costs are important. E-commerce volumes are low (for now), but margins are high considering overheads are close to nonexistent, and outlets let textile companies clear slow moving or damaged inventory without resorting to significant discounting in its retail or department store channels. Demand is driven by the economic environment, retail sales expectations, and the health of retail balance sheets. When the economic environment is strong, textile manufacturers receive consistent orders from their wholesale clients as department stores replenish inventories. However, when retailers expect sales to slow, they will reduce inventories to avoid having to discount slow-moving or unwanted merchandise. Also, most retailers fund inventory purchases through short-term borrowing. If a retailer’s balance sheet is weak, its borrowing costs will typically be expensive, reducing its ability to make large inventory

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purchases and limiting sales growth for the textile producer. These drivers distinguish textile companies from their retail cousins, and understanding their interaction will give you an edge in determining where and when to invest. Luxury Goods Luxury goods manufacturers like LVMH, Richemont,

Hermes, and Bulgari sell a wide variety of high-quality products at a price reflective not only of said quality, but also of prestige and exclusivity. Luxury goods use expensive raw materials, are labor intensive to produce, and in some cases (like fine wines or cognac), take years to bring to market. While the luxury demographic is wealthy enough to be somewhat insulated from economic conditions, economic growth is still a demand driver—a growing economy expands the luxury demographic as new sets of consumers trade up to luxury goods. Another demand driver is stock market performance—the households whose wealth is largely unaffected by economic growth derive income from assets like equities. When asset values decline, so too does their spending power. CONSUMER SERVICES INDUSTRY GROUP The Consumer Services industry group breaks down into the following sub-industries: • • • • • •

Restaurants Hotels, Resorts & Cruise Lines Casinos & Gaming Leisure Facilities Education Services Specialized Consumer Services

When commentators refer to the US economy as becoming “service-based” rather than manufacturing-based, the services provided by these sub-industries aren’t exactly the ones to which they refer. Financial and health care services represent the lion’s share of spending

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on services, not the restaurants, barbers, and casinos found in this industry group. At 13 percent, Consumer Services is the smallest portion of the MSCI ACWI Consumer Discretionary sector and just 1.1 percent of the total index. Restaurants

Restaurant demand is influenced by a host of factors, including general economic trends, proximity to major population centers or worksites, and consumer preferences, among many others. As with retailers, same store sales are usually the most important gauge of sales. Restaurateurs must manage food, labor, rent, and other miscellaneous expenses, all of which can be volatile. In addition, store maintenance, renovations, and marketing are important (and often expensive) considerations. Companies operate under two formats: franchised or company-owned. Under a franchise arrangement, the restaurant company allows another entity to own and operate its restaurants for a percentage of revenue or profit in return. Restaurant companies using a franchise system earn less revenue per store, but are not exposed to as much expense volatility. All things being equal, companies with a large percentage of franchised stores will outperform in periods of commodity inflation and underperform when input costs are relatively cheap. Hotels, Resorts & Cruise Lines

Like Restaurants, the premise of the hotel business is simple. Demand is driven primarily by general economic conditions, proximity to business or tourism centers, and fuel costs. Major expenses include labor, rent or lease payments, maintenance and repairs, and advertising. Hotels are also exposed to food and beverage inflation. In recent years, many hoteliers have opted to franchise their portfolios rather than bear the costs of direct ownership. Like restaurants, this theoretically reduces profit volatility while freeing up capital for expansion.

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Cruise Lines operate like floating hotels, adding fuel expenses and other maritime operating costs to the expense line. The flight to the departing port is often the most expensive cost for cruise customers, linking cruise demand to both economic conditions and trends in airline travel. Cruise lines earn profits through booking fees and high-margin onboard sales of alcohol and services like massages. Casinos & Gaming and Leisure Facilities

The emergence of the mega-resort and casino marked a significant departure from the dingy, smoke-filled dens of Las Vegas’ past. Companies in this segment plan, develop, and operate major resorts and casinos. Diversifying away from gaming, modern casinos offer a range of accommodations, entertainment, restaurants, and often include a large retailing area. Driven by economic growth, convention spending, destination seeking, and the lure of gambling, demand can be volatile. A labor-intensive business, significant capital is required for up-front development and ongoing maintenance. Casinos can be immensely profitable in economic expansions—however, investors should be aware of the government’s control over granting gambling licenses and levying special taxes. Both can make or break even the largest player. Specialized Consumer Services

This segment includes companies that can’t be classified anywhere else. They provide a service, but have little in common beyond that. Education providers Apollo Group, DeVry, and Rosetta Stone provide post-secondary education in non-traditional formats. Tax preparer H&R Block provides accounting and investment services. Service Corporation International and Hillenbrand Inc. provide funeral services and caskets. Photo studios, auction houses, beauty salons, and myriad miscellaneous businesses are included in this segment. Specific demand for each company’s service tends to be more impactful than economic trends.

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Chapter Recap The breadth of the Consumer Discretionary sector can be daunting, so understanding each industry group’s operations and how demand is converted to profit is important. Consumer Discretionary companies provide goods and services primarily to individuals. Understanding industry-specific dynamics like barriers to entry, inventory management, location planning, and funding considerations can add another layer to your analysis. The Automobiles & Components, Retailing, and Media industry groups are the largest—these segments should receive the majority of your analysis and attention, although Consumer Durables and Services should not be overlooked. Developed markets have larger Consumer Discretionary weights than emerging markets, while large-cap indexes have smaller Consumer Discretionary weights than small-cap indexes. • The Automobiles & Components industry group includes automobile manufacturers and component suppliers. Economically sensitive demand, significant barriers to entry, and government regulation characterize the largest Consumer Discretionary industry group. • The Retailing industry group contains Specialty, Multiline, and Internet & Catalogue Retailers, in addition to Distributors. Leverage to consumer spending and the importance of location, inventory, and merchandise planning characterize this segment. • The Media industry group includes Movies & Entertainment, Cable & Satellite, Publishing, Broadcast & Advertising companies. Diverse revenue and profit drivers limit generalizations; however, most Media companies create and distribute content in return for circulation and advertising revenue. • The Consumer Durables industry group contains primarily Consumer Electronics and Homebuilding firms. Consumer electronics manufacturers rely on economic strength, economies of scale, and massive R&D budgets to support growth, while homebuilders are often regionally concentrated and less important to overall returns than many assume. • The Consumer Services industry group includes Hotels, Restaurants, and Casinos, among others. This segment is characterized by the importance of expense management and franchising strategy.

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5 CHALLENGES IN THE CONSUMER DISCRETIONARY SECTOR

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ach stock market sector faces a unique set of business and economic hurdles. This chapter explores two major challenges for Consumer Discretionary firms: finding ways to grow profits in mature markets and managing volatile demand. Understanding these challenges will help you judge management efficacy and analyze the likelihood of a company missing, meeting, or beating profit forecasts. CHALLENGE 1: GROWING PROFITS IN MATURE MARKETS The majority of Consumer Discretionary firms are found in large, developed economies. For industry leaders like Toyota, McDonald’s, or Target, revenue gains in major markets from traditional sources like expanding store counts or distribution are limited. This contrasts with developing economies, where vast geographic regions may yet to be penetrated. Consumer Discretionary firms seek consistent growth in operating income. This requires steady revenue growth, improvements to cost 91

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structures, or some combination of both. Growing revenue in a mature market is primarily achieved through market share gains, while lasting cost reductions are usually driven by improving operational efficiency. Building Market Share

In a vacuum, market share is almost meaningless. What if a company has 100 percent market share in washboards or VCRs? Or maybe it has 30 percent market share in tennis racquets? Market share must be large relative to competitors, but also relevant. It’s obvious why 100 percent VCR market share is close to worthless—no one cares much about dominance in an archaic product—and in the tennis racquet case, what if its closest competitor has the other 70 percent of the market? That 30 percent may not seem so great anymore, and acquiring additional market share may seem impossible. In contrast, a firm with just 20 percent market share may actually be in a great position if the next three competitors have 8 percent, 4 percent, and 3 percent market share. You must dig deeper to understand the competitive landscape. Also, when evaluating market share, it is important to understand the benefits of strong market share so you can judge if a company is executing on this important advantage. Companies with strong relative market share have more sales across which to distribute production, development, and corporate costs, generating richer profit margins. They also have more latitude to invest in future development or reduce prices when consumer spending is weak. A high relative market share is a powerful strategic attribute. The primary way companies build market share is through: • Effective marketing and promotions • Product innovation • Acquisition Marketing and Promotions Used effectively, a good marketing campaign—including traditional advertising, branding, and promotions— can earn a company lasting market share gains and valuable brand loyalty.

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Relying on a mix of sponsorships and promotions, sporting goods manufacturers vie for a share of a highly competitive (and profitable) market. An example: Callaway Golf, one of the world’s leading manufacturers of irons and putters, successfully garnered more market share during the 2008 economic downturn. A weak economy can be particularly damaging for golf club sales, so Callaway began an extensive online advertising campaign, offering “Buy One, Get One Free” promotions on a variety of drivers and irons. Although revenue continued declining, Callaway reported an additional 3.1 percent market share gain in the US.1 Moreover, with discounted goods flying off the shelves, the company cleared enough inventory to introduce its 2010 line of clubs earlier than expected. Golfers are notoriously “sticky” customers—once a golfer finds a club he’s comfortable with, he can be loath to change brands. This being the case, Callaway’s market share gains may result in larger profits as the economy rebounds. Promotions are just one type of marketing. Tiffany & Co., the world’s second largest luxury accessories firm behind Richemont’s Cartier (by sales), has one of the world’s most recognizable (and therefore valuable) brands. According to management, the Tiffany brand is its “single most important asset.”2 Tiffany’s jewelry generally isn’t complicated design-wise—emphasizing heart-shaped designs made of silver, gold, or platinum, and simple solitaire diamond rings. So why can’t someone else make the same thing and steal market share? It’s not for lack of trying. But the Tiffany brand is intended to evoke an experience and emotional reaction. The 1961 movie, Breakfast at Tiffany’s, is iconic and the company’s high-brow store locations reinforce the company’s image as the pinnacle of luxury and class. It doesn’t hurt that nearly every woman in the US recognizes Tiffany’s blue boxes (in fact, the company holds a color trademark on “Tiffany Blue” in the US). The power of Tiffany’s brand has made its existing market share more durable over time against competitors. No single marketing strategy is appropriate for all market conditions. Understanding the goal of a firm’s marketing strategy can help you form an opinion of whether it’s a long-term positive or negative. In Callaway’s case, the company was willing to trade short-term

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profitability for market share. Tiffany, on the other hand, refused to materially discount its jewelry in 2008 and 2009, betting that lower prices would dilute the prestige of its brand and erode its market share. Only time will tell. Product Innovation Another way firms can boost market share is

through product innovation. By introducing new products, technologies, or services at an affordable cost, firms can earn a larger share of industry revenues. For example, the late 1990s marked the beginning of a digital content revolution, spurring a technological revolution in TV technology. In the US, movies stored on digital versatile discs (DVDs) were released in 1997. High definition (HD) TV broadcasts began about a year later. Both technologies were slow to catch on despite offering significantly improved audio and visual clarity. Although no one could say the new formats weren’t an improvement, existing TV screen resolutions were too poor and the new digital feeds didn’t make much of a difference to casual viewers. Seeing an opportunity, manufacturers began developing HD-ready flat panel TVs, relying on new technologies like liquid crystal displays (LCDs) and plasma display panels (PDPs). As TVs caught up with new storage and broadcast formats, two market share shifts occurred. The first was away from traditional, cathode ray tube (CRT) TV sets toward LCD or PDP sets. As late as 2005, CRT was still the dominant technology, representing over 80 percent of total global TV shipments.3 But by 2009, the shift toward digital formats propelled LCD and PDP global shipment share to nearly 75 percent.4 The second market share shift is still under way as improvements to LCD technology continue to erode market share for PDP manufacturers. Early plasma sets had a clear quality advantage over LCD, with higher refresh rates and superior contrast ratios providing crisper images and colors. By 2005, 20 percent of global flat panel TV shipments were plasma sets. Since then, LCD manufacturers have closed the quality gap significantly. By 2009, LCDs featured higher refresh rates, sharper contrast ratios, and lower energy consumption than

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plasmas. As such, companies manufacturing LCD TVs, like Samsung and Sony are gaining market share while plasma manufacturers like Panasonic are not. By marketing improvements to LCD technology while highlighting limitations in plasma technologies like screen burn and higher energy consumption, LCD manufacturers have increased their share of flat panel television shipments to 91 percent in 2009 from 80 percent in 2005. While major PDP manufacturers like Panasonic and Samsung point to technological improvements minimizing screen burn and energy consumption along with lower prices, the benefits of overwhelming market share—like economies of scale and consumer familiarity—are accruing to the LCD camp. Acquisitions Acquiring a competitor can be a quick way to build

market share, especially in a saturated market dominated by wellestablished firms. While there are a number of issues to consider when evaluating the pros and cons of an acquisition that are outside the realm of this book, acquisitions (done right) can be highly accretive to earnings while building lasting market share. Whirlpool’s 2006 acquisition of Maytag is a great example. In 2004, the global appliance industry was dominated by four firms: Whirlpool, GE, Electrolux, and Maytag. These firms controlled about 93 percent of the “Core 6” appliance industry, which includes washers, dryers, freezers, ranges, dishwashers, and refrigerators.5 America, the world’s largest appliance market, was in the midst of a housing boom. Most of the industry was benefiting from growing sales and lower production costs tied to moving manufacturing overseas. Maytag, however, was struggling. Once known for its quality and dependability (you may remember the TV commercials with the bored, idle repairman), a series of missteps in the early 2000s had the company, “a 2-inch putt from bankruptcy.” 6 Competition from new appliance manufacturers was eroding market share, while its manufacturing costs were higher than peers due to its failure to move production to lower-cost markets. Cumbersome debt payments from prior acquisitions handcuffed new product development. With

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product quality falling, Best Buy stopped carrying Maytag products and Home Depot significantly scaled back Maytag’s floor space. By mid-2005, Chinese appliance maker Haier had partnered with two investment firms to make a bid for Maytag. With 15 percent of North American Core 6 market share, acquiring Maytag would provide Haier immediate entrance to the world’s largest appliance market. Over the ensuing months, industry-leader Whirlpool (who controlled about 33 percent of North America’s Core 6 market) made a series of competing bids and eventually won approval to acquire Maytag for $2.8 billion in cash, stock, and assumed debt. The combined entity had an overwhelming 48.5 percent market share in North American Core 6 products, with certain categories like washers reaching a combined 75 percent share.7 Shareholders cheered the takeover as Whirlpool increased its market share by approximately 50 percent overnight. Additionally, its increased scale combined with Maytag’s outdated manufacturing footprint meant significant opportunities for cost cutting.

Analyzing M&A How does M&A impact the sector? It depends on how deals are transacted. When one firm acquires another by paying cash (either with cash on hand or with borrowed funds), the acquired firm ceases to exist as an independent, publicly traded firm. Those shares are removed from the market and sector share supply declines. Because stock prices are dictated by supply and demand, this should have a positive impact on prices if the demand for Consumer Discretionary shares remains constant or rises. This bullish force becomes more powerful if the sector as a whole experiences a high level of cashbased mergers. But mergers can also be transacted in stock. For example, Firm A is worth $20 billion and Firm B is worth $10 billion—$30 billion in total stock supply. Say Firm A wants to buy B. Usually they’ll pay a premium, maybe 20 percent—$12 billion. Firm A issues $12 billion in new Firm A stock, and B ceases to exist. Except where we once had $30 billion in total stock supply, we now have $32 billion. If this happens broadly, this

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can have a negative impact on prices sector-wide if demand for Consumer Discretionary shares doesn’t keep pace. Deals can also be transacted partially in cash, partially in stock. For example, Firm A might pay a hybrid of $6 billion in cash, $6 billion in stock for B. But most cash/stock deals tend to result in lower overall supply, which can be a bullish factor. How do you know when cash-based deals or cash/stock hybrid deals are more likely to occur? Watch bond yields and earnings yields. A bond yield represents a firm’s borrowing cost. The earnings yield is the reverse of the P/E ratio—the E/P (earnings per share over price per share). When earnings yields are higher than bond yields, a firm can borrow cheaply and buy a higher earnings yield—the difference between the higher earnings yield and the lower bond yield is profit. Done right, the deal finances itself and is immediately accretive to the acquirer’s earnings. The acquirer’s earnings per share rises, and, all else being equal, share price should follow. This is powerful incentive for CEOs to make acquisitions (or buy back their own shares—the same concepts apply). Periods likely to see a higher rate of mergers and acquisitions are when interest rates are generally benign and bond yields are lower than earnings yields—just as we saw in 2005, 2006, and 2007. That’s the sector-wide impact, but the effect on individual stocks can be subject to other considerations entirely, at least in the short term. In the very near term, sometimes Wall Street reacts favorably to deal news, sometimes negatively. As an investor, it’s critical you understand how a deal impacts a firm for the longer term and don’t get swayed by near-term knee-jerk reactions. For a deal to work, firms should find targets that fit well into their existing business or somehow introduce a new, competitive value proposition.

Improving Operational Efficiency

Many of the same benefits gained by building a larger relative market share can also be attained by having an efficient cost structure. Lower expenses result in richer profit margins, supporting ongoing product investment and price flexibility in down markets. Additionally, firms with well-managed supply chains can run slimmer inventories, freeing up capital for investment and providing flexibility to meet rapid demand changes. Moving manufacturing to low-cost regions, improving supply chain performance, and managing expansion are just a few ways Consumer Discretionary firms maximize cost structure efficiency.

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Ceteris Paribus When discussing the impact of operational efficiencies, it’s important to take into account ceteris paribus—from the Latin roughly translated to “all things being equal.” Although we can make logical arguments for why higher market share or more efficient manufacturing and supply chain management should be good for profit margins, extraneous factors often muddle the analysis. For example, although Whirlpool’s acquisition of Maytag should have been tremendously accretive to earnings (all things being equal), runaway commodity inflation and the bursting of the housing “bubble” actually weakened margins following Whirlpool’s Q2 2006 Maytag acquisition.

Many firms have already moved production to low-cost economies, but there are still plenty of opportunities for improvements. By moving production facilities to regions with lower labor, utility, sourcing, or shipping expenses, a firm can reduce its marginal cost of production without sacrificing quality or service. The marginal cost of production is simply the cost associated with producing an additional unit. Holding prices constant, firms with low marginal production costs relative to peers earn more profit per unit and can maintain profitability at lower price levels. In general, manufacturing in economically developed regions is more expensive than in developing economies. While it may seem like a no-brainer to move production to the lowest-cost region, several factors can keep a firm from overhauling its manufacturing base. A unionized workforce can impede a firm’s ability to inexpensively outsource jobs. Plant efficiency or quality can diminish once outside of management’s direct control. Logistical issues can complicate cost savings. Any number of trade or political disputes can also negatively affect earnings/productivity. For instance, it may be cheaper for a US retailer to manufacture clothes in Vietnam, but inexperience managing the volatility of shipping costs can quickly erode incremental cost savings. Furthermore, foreign currency exposure must be strategically managed.

Greener Pastures

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Managing the Supply Chain A supply chain is the system through which a product or service is transferred from a supplier to a customer. A well-managed supply chain provides management oversight of quality control, flexibility to reduce or increase inventories, the ability to quickly respond to changing demand levels or trends, and, ultimately, stronger gross margins. In general, supply chain activities can be broken down into product planning, sourcing, production, and distribution. We’ll briefly touch on examples of firms that have successfully managed each.

• Product planning: Planning merchandise for a globally diversified apparel company isn’t easy. Polo Ralph Lauren, one of the world’s leading apparel manufacturers, impressed shareholders in mid-2009 by expanding its gross margin 5.2 percent quarter over quarter despite sales falling 20.7 percent over the same period.8 It accomplished this by planning its merchandise assortments earlier and consolidating orders with fewer suppliers. With extra lead time and larger shipments, the company saved money by shipping via boat rather than air. • Sourcing: Sourcing is all about reliably accessing supplies at the lowest possible cost. There are several ways to do it—firms can manufacture their own goods, source directly from a third party, or use a vendor. The goal is maximizing initial mark up (IMU). For example, if a $15 hat costs a company $5 to buy from a third party and only $4 to produce on its own, it will choose the lower cost option to maximize IMU. Dress Barn, a specialty retailer of women’s apparel, favors direct sourcing. By consolidating large orders with small vendors, Dress Barn can negotiate more favorable prices and ensure product quality. Indeed, over the last five years, Dress Barn’s gross margin averaged 39 percent versus 35.5 percent for its peers.9 • Production: Managing a manufacturing operation is complex, especially for automobile manufacturers with globally diversified production and distribution networks. Toyota, one of the world’s largest automobile manufacturers, manages

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disparate regional preferences and demand levels—in addition to currency exposure—by building significant overseas manufacturing capacity. For example, in response to strong demand for SUVs in its North American market, Toyota built dedicated SUV manufacturing plants in Texas and Indiana with annual capacity of 470,000 units to better meet local demand and reduce exposure to the USD.10 (Please see Fisher Investments on Industrials for a more in-depth review of manufacturing-specific considerations.) • Distribution: Once a firm has a finished product in its inventory, it needs to determine how to most efficiently get it to its customers. Whether delivering goods to its own stores, retail partners, or directly to the consumer, firms with efficient distribution systems incur lower transit costs per unit and tie up less capital in inventory. Amazon.com, the world’s leading Internet & Catalogue retailer, can keep prices low by managing a network of over 15 US distribution centers. Over the last 10 years, the firm has turned over its entire inventory an average of 13 times per year.11 For reference, Target turns over its entire inventory 6.5 times.12 This boosts the return Amazon.com earns on its inventory investment, while freeing up capital for additional investment. Managing Expansion One of the easiest ways to boost profits as

a growing company is to expand. However, expansion can challenge management by blurring its focus on the existing business. Starbucks, the world’s largest coffeehouse, is a great example. When it went public in 1992, it had 119 stores. By the end of 1998, it had 1,886 locations. A decade later, in 2008, it had 16,680.13 Over that 10-year period, Starbucks’ stock outperformed the S&P 500 by an annualized 6 percent per year. Its success prompted the company to experiment in different businesses like food, music, and consumer products. But by the end of 2008, something had changed. Gross margins had fallen to 52.7 percent, a noticeable decline from the previous 10-years’ average of 57.7 percent.14 Similarly, its operating margin slipped

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to 3.1 percent after averaging 9.6 percent over the same period.15 What happened? According to CEO Howard Schultz, Starbucks expanded too rapidly while losing sight of its core competency. He went on to say the theater of the Starbucks experience—the sound of beans being scooped, the smell of freshly roasted coffee, and the sight of baristas pouring espresso—had been lost amid an unrelenting focus on store expansion.16 Schultz attributed the sudden deceleration in same-store sales to those two factors rather than a weakening economy. Don’t be fooled; this is a CEO’s way of deflecting attention from one thing and one thing only—Starbucks over-expanded and paid the price. To turn the company around, Schultz implemented a number of initiatives, including fewer store openings, nearly 1,000 store closures, and a renewed focus on coffee. It announced the closure of 800 stores in the US and about 160 internationally in 2008. New store plans for that year were reduced to 900 from an initial 1,600.17 To refocus on the coffee brewing experience and ensuring quality the company had been known for, it closed all its stores to give its employees a refresher on brewing coffee. The training was advertised as a way to get back to their “roots,” but it was really a way to retrain its employees to boost efficiency and reduce product waste. It discontinued certain food items that distracted from the aroma of fresh brewed coffee and outsourced its media operations to a third party. By the first quarter of 2009, gross margins began to improve. With underperforming stores closed, waste reduced, and expansion limited, margins began growing anew. Over the next two quarters gross margins increased to 56.6 percent from 52.7 percent just three quarters earlier, with operating margins more than tripling to 9.4 percent from 3.1 percent over the same period.18 CHALLENGE 2: MANAGING VOLATILE DEMAND With few exceptions, all companies face demand volatility. Energy firms deal with fluctuating oil prices, Materials firms face global inventory gluts, and Technology firms can be whipsawed by new product

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breakthroughs. In each of these examples, demand volatility is most pronounced at the margins as each company’s revenue stream has underlying replacement demand. A Materials company, for example, may sell chemical lubricants to a factory to keep its machines running smoothly. That factory might reduce orders marginally during an economic downturn, but it won’t cut orders entirely because it requires the lubricant to keep production rolling. For Consumer Discretionary firms, replacement demand is unreliable, meaning marginal demand trends have a much larger impact on overall revenue. This is a byproduct of the nature of discretionary purchases—by definition, these aren’t necessities, so when times get tough they are often the first purchases to be cut. Accounting “Rules” Although it makes infinite sense for all firms to follow a single set of accounting guidelines, that frequently doesn’t happen. In this section, the cost of goods sold income statement line item is used to illustrate expense leveraging. But be careful! Not all firms account for cost of goods sold the way we do here. In fact, there’s nothing in the Generally Accepted Accounting Principles (GAAP) or the International Financial Reporting Standards (IFRS) that says they have to. For example, Nordstrom and Macy’s are two very similar firms that account for expenses in highly dissimilar ways. Just one difference: While Nordstrom accounts for store leases, buying costs, and depreciation as part of cost of goods sold, Macy’s accounts for these same items as part of selling, general, and administrative (SG&A) expenses. The result is Nordstrom’s gross margin appears much lower than its peers; however, if one manually calculated its gross margin using consistent accounting rules, that would not be the case. As you conduct your own analysis, make sure you know how the firms you’re comparing account for expenses. These seemingly small differences can have a big impact.

The impacts of volatile demand primarily influence revenue, profitability, and inventories. To illustrate how these factors affect a company’s operations, we’ve created three scenarios for an imaginary automaker—Fion Motors—to manage. In 2007, Fion Motors earned

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$100 million in revenue. Its cost of goods sold was $80 million. Cost of goods sold includes direct variable costs like raw materials and labor, and direct fixed costs like lease and utility payments on plant, property, and equipment. Gross profit (revenue minus cost of goods sold) was $20 million, resulting in a gross margin of 20 percent. This is depicted in Table 5.1. As shown in Chapter 4, automobile demand can be highly volatile. Table 5.2 illustrates three different revenue growth scenarios, ranging from modest demand growth (10 percent), more aggressive growth (60 percent), and a decline (–30 percent). Recall that demand fluctuations generally have a large impact on gross margins. This is because a portion of the cost of goods sold line item is relatively fixed (plant utilities, for instance). In Table 5.3, note how variable costs change along with demand (this makes sense—if a company sells 60 percent more cars, it needs 60 percent more raw materials) but fixed costs remain static. This is called operating leverage. Table 5.1 Fion Motors 2007 Gross Margin ($ in millions) Fiscal Year 2007

Calculation

$100

N/A

Direct Variable Costs

$ 30

N/A

Direct Fixed Costs

$ 50

N/A

Total Cost of Goods Sold

$ 80

Variable Costs plus Fixed Costs

Gross Profit

$ 20

Revenue minus Cost of Goods Sold

Revenue Costs:

Gross Margin

20%

Gross Profit divided by Total Revenue

Table 5.2 Fion Motors 2008 Revenue Growth ($ in millions) 2007 Revenue 2008 Demand Growth 2008 Revenue

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Scenario One

Scenario Two

$100

$100

+10% $110

+60% $160

Scenario Three $100 –30% $ 70

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Table 5.3 Fion Motors 2008 Cost Progression ($ in millions) Scenario One

Scenario Two

Scenario Three

Direct Variable Costs

$30

$30

$30

Direct Fixed Costs

$50

$50

$50

Total Cost of Goods Sold

$80

$80

$80

+10%

+60%

–30%

0%

0%

0%

2007 Costs:

2008 Cost Growth Direct Variable Costs* Direct Fixed Costs 2008 Costs: Direct Variable Costs

$33

$48

$21

Fixed Variable Costs

$50

$50

$50

Total Cost of Goods Sold

$83

$98

$71

*All things being equal, direct variable costs will move along with sales growth.

Table 5.4 Fion Motors 2008 Gross Margin ($ in millions) Scenario One

Scenario Two

Scenario Three

2007 Revenue

$100

$100

$100

2007 Cost of Goods Sold

$ 80

$ 80

$ 80

2007 Gross Profit

$ 20

$ 20

$ 20

2007 Gross Margin

20%

20%

20%

2008 Revenue

$110

$160

$ 70

2008 Cost of Goods Sold

$ 83

$ 98

$ 71

2008 Gross Profit (Loss)

$ 27

$ 62

($1)

2008 Gross Margin

24.5%

38.8%

–1.4%

2008 Gross Profit Percent Change

35.0%

210.0%

–105.0%

When we calculate gross profit based on the three different scenarios, the impact of volatile demand becomes clear. Table 5.4 illustrates this dynamic. Scenario One illustrates how operating leverage works. There’s nothing specific to Consumer Discretionary stocks in operating leverage, but, as we noted previously, volatile demand is a major consideration for Consumer Discretionary stocks.

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Scenario Two shows how quickly profit margins can expand when revenue is growing. While larger profit margins are rarely considered a “challenge” for companies in the sector, large, sudden upswings in demand can occasionally cause headaches for managers. For instance, if inventories are insufficient to cover demand, a company can lose sales to a competitor. This is particularly damaging for manufacturers of big-ticket items. Also, rapidly shipping additional inventory to a high-demand market may result in higher-than-forecast supply chain expenses. In general, investors are more than willing to endure these risks. Scenario Three shows how a 30 percent sales decline can lead to a 105 percent drop in gross profits—resulting in a loss. There are three main risks to this kind of volatility. First, weaker profits mean fewer dollars available for future product development and for general corporate purposes. Next, weaker-than-expected sales result in largerthan-expected inventories as unsold goods accumulate. (See nearby box for more on inventory risk.) Finally, many Consumer Discretionary firms rely on revolving lines of credit for the majority of their short-term funding. These lines of credit come with debt covenants stipulating minimum profitability ratios relative to debt, among other things. When profits fall, companies may need to renegotiate their credit agreements, often on unfavorable terms. Sometimes, profits weaken so dramatically relative to debt that banks refuse to negotiate workable credit terms, occasionally resulting in bankruptcy.

A Note on Inventories It’s easy to focus solely on revenue gains and profit pains, but for many firms, inventories are where much of the game is won or lost. Buy too much and risk seeing warehouses full of unwanted goods destined for the clearance rack (read: no profit). Buy too little and watch your competitors earn what would have been your revenue. Inventories are purchased with cash on hand, cash flow from operations, or through short-term borrowing. Rarely do firms pay for inventories up front. In most cases, a firm (Continued)

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will take delivery of inventory and pay for it 60 to 90 days later after it’s had a chance to sell the products. When sales are weak and inventories swell, firms can either cut prices to clear out their warehouses and pay their vendors, or they can leave prices where they are and pay for unsold inventory with cash or borrowings. This is where things can get tricky. For many Consumer Discretionary firms, revolving credit lines represent a major portion of debt financing. To maintain full borrowing capacity, companies must comply with debt covenants. Debt covenants can be found in the company’s credit agreement. One of the most common debt covenants requires firms to maintain a minimum level of profitability relative to net debt. Although this is called the leverage ratio in credit agreements, we should not confuse it with financial leverage, which is simply debt/ equity. To calculate leverage by the definition in a credit agreement, take net debt (total debt minus cash) divided by trailing 12-month EBITDA (earnings before interest, taxes, depreciation, and amortization). When firms are forced to borrow to fund inventory or use cash, net debt grows, increasing the leverage ratio. To reduce net debt, managers can discount inventory to clear the way for new products and free up capital for investment, reducing profits. If lower pricing isn’t enough, production can be cut. Production cuts reduce marginal profitability as fixed costs are spread over fewer units. Lower profits also increase the leverage ratio. When sales fall rapidly, companies can find themselves in violation of debt covenants and without access to financing. Often, this is the first step toward bankruptcy.

Firms with strategies to manage volatility can use demand hiccups to their benefit. Adjusting prices to clear inventories, cutting costs to soften margin declines, and renegotiating lines of credit to ensure access to funding are all ways firms can offset the harsh reality of downside demand volatility. Demand disruptions provide opportunities for investors who can identify a company using industry volatility to its advantage. CASE STUDY: CALLAWAY GOLF Let’s examine how one company handled some of the Consumer Discretionary sector’s biggest challenges. Callaway Golf faced significant

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demand volatility as economic concerns and restricted access to credit combined to weaken US durable goods spending. With profit falling and debt on the rise, it looked increasingly likely Callaway would violate its debt covenants. In response, management took decisive steps to reduce inventory and strengthen its balance sheet, while gaining market share at the same time. Bad to Worse

By early 2008, US consumer spending on durable goods weakened— year-over-year growth was just over 1 percent, down from 2007’s average growth of around 5 percent. The soft housing market and concerns over sub-prime mortgage losses combined to unnerve consumers, and during 2008, US durable goods spending fell 4.3 percent versus 2007. However, revenues at Callaway were resilient, falling less than 1 percent over the same period. But in the first quarter of 2009, quarterly revenue fell a whopping 25.8 percent year over year, taking management (and investors) by surprise. The immediate impact of the first quarter sales decline was a 32.9 percent drop in gross profit. Lower unit sales resulted in weaker fixed cost absorption, pushing gross margins down 4.9 percent versus the prior year quarter. Net income sank to $6.8 million from $39.7 million the year before, resulting in a $17 million cash outflow and 50 percent less cash on hand. As a result, Callaway was at immediate risk of violating its debt covenants—specifically its leverage ratio.

Calculating Leverage for Debt Covenant Review To calculate Callaway’s leverage ratio (by the definition provided in its credit agreement) simply take total debt and divide it by the sum of the previous four quarters’ EBITDA. Callaway’s leverage ratio must be below 2.75. Table 5.5 illustrates the calculation after Callaway’s first quarter earnings release. For Q1 2009, you’d calculate the ratio by adding the last four quarters’ EBITDA ($24.9 ⫺ $19.4 ⫺ $3.0 ⫹ $70.8) and dividing (Continued)

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the sum by debt ($147.1) as of Q1 2009. The result is 2.0, which complies with the requirement to stay below 2.75.

Table 5.5 Leverage Ratio, Callaway Golf ($ in millions) Period

EBITDA

Debt

Leverage Ratio

Q1 2006

$ 43.6

$ 85.0

1.5

Q2 2006

$ 46.7

$110.3

1.7

Q3 2006

$ (8.2)

$ 60.0

1.1

Q4 2006

$(12.8)

$ 80.0

1.2

Q1 2007

$ 64.9

$155.0

1.7

Q2 2007

$ 70.7

$ 55.4

0.5

Q3 2007

$ 10.7

$ 0.9

0.0

Q4 2007

$(20.8)

$ 36.5

0.3

Q1 2008

$ 17.8

$155.6

2.0

Q2 2008

$ 70.8

$135.0

1.7

Q3 2008

$ (3.0)

$ 40.0

0.6

Q4 2008

$(19.4)

$ 90.0

1.4

Q1 2009

$ 24.9

$147.1

2.0

Source: Bloomberg Finance, L.P.

Due to seasonality, Callaway accumulates debt in the first and second quarter and repays it in the third and fourth. This, along with Callaway’s cash on hand of $19.5 million at the end of the quarter, suggested meaningful debt repayment was unlikely. Also, with economic conditions showing no signs of improvement, management predicted it would need to renegotiate its line of credit during the second quarter to avoid violating its leverage debt covenant. Making Lemonade Out of Lemons

Facing a material debt covenant violation against a backdrop of continued demand and profitability declines, Callaway was in trouble.

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One quarter’s demand volatility was threatening to significantly disrupt Callaway’s operations. Yet, three months later, the firm had gained market share, reduced inventories, and paid off 100 percent of its outstanding debt. It was a remarkable feat—but how did they do it? The first issue management tackled was reducing inventory. As mentioned earlier in the chapter, aggressive Buy One Get One Free promotions—along with inventory destocking at the retail level and broad economic weakness—resulted in second quarter sales falling 17.4 percent versus the prior year. However, heavy discounting drove improved unit demand, evidenced by higher quarterly inventory turnover and a 3.4 percent reduction in total inventories. Inventory reductions boost cash flow while clearing shelves for new products. Improving unit sales along with a new product rollout resulted in a 3.1 percent market share gain. Despite its success clearing out inventory and freeing up cash, persistent economic weakness and heavy discounting do not support strong EBITDA growth, meaning Callaway still needed to address its debt covenants. Callaway’s line of credit was provided by a syndicate of eight banks. To amend its debt covenants required the approval of the syndicate. Often, relaxed debt covenants accompany higher interest rates, which can limit profits, so occasionally other options are more attractive than a renegotiation. Rather than suffer higher interest rates on a debt renegotiation, Callaway issued $140 million in preferred, convertible equity. While the new share issuance was 31.5 percent dilutive to existing equity investors, the proceeds from the share sale along with cash generated through inventory reductions allowed Callaway to pay off all its debt and end the second quarter with $50 million in cash on hand. By acting decisively in the face of highly volatile demand, Callaway gained market share, reduced inventory, and strengthened its balance sheet. While detrimental to profits in the near term, the steps management took likely position the company well for future growth.

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Chapter Recap

• • • • •

• Many Consumer Discretionary companies generate the majority of revenue and profits in economically mature markets, limiting growth to traditional means like store openings. This requires relentless managerial focus on growing market share, reducing costs, or both. Advertising, superior product quality, and acquisitions can boost market share. Efficiencies in sourcing, planning, producing, and distributing goods and services can minimize costs. Consumer Discretionary companies face significant demand volatility, which can impact more than just profitability. Inventory quality and compliance with debt covenants are two often overlooked factors. Understanding how Consumer Discretionary companies grow profits in mature markets along with managing demand volatility is vital to any analysis of Consumer Discretionary stocks.

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6 HOUSEHOLD DEBT—MYTHS AND OPPORTUNITIES

I

f you thought we made an omission in Chapter 3 (Consumer Discretionary Sector Drivers) by leaving out access to credit as a driver of consumer spending, you’d be wrong. Credit access has myriad economic benefits. People like to demonize debt, but imagine a world where no one can borrow. It’s a world where most people can’t easily buy homes, cars, go to college, or maybe even buy a suit for their first job interview. Hardly an ideal world. Simply, credit bridges a gap between current expenses and future income. Consumers needn’t save the entire price of a car before buying one; they can take a loan against their future wealth and buy it today! Credit can also add to an investor’s return through the power of leverage. If the cost of borrowing is less than the return on the asset, the spread between the two is profit (less transaction and other related costs). Individuals do this most frequently through mortgages, and businesses do it every time they draw on a line of credit or issue bonds to fund operations. 111

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But there’s a common, widely held belief that today’s consumer spending is largely driven by credit—that, absent of credit cards and home equity lines of credit, consumer spending would radically dry up. This chapter will show how credit is not the significant driver in developed markets many believe; however, at the same time it represents a tremendous opportunity in emerging markets. If any of this appears counterintuitive, that’s good—investment opportunities often hide behind counterintuition. HOUSEHOLD DEBT IN DEVELOPED MARKETS— BASICALLY A VERY USEFUL TOOL Credit is an easy target when the economy weakens. For example, a common story throughout 2008 and following the credit crisis that fall was that the last 10 years of consumption growth were attributable mostly to a “credit binge.” Many news stories hypothesized that consumers had “overleveraged” themselves by taking advantage of low interest rate mortgages and invitations in the mail to sign up for preapproved, low APR credit cards. But attributing years of consumption growth to credit expansion alone ignores the impact of economic growth on disposable income and spending. In developed markets, growth in disposable income—not credit—is the most significant driver of consumer spending. Although disposable income is the key driver of discretionary spending, we should point out 2008’s “credit crisis” certainly contributed to a slowdown in spending, just not in the way many people

Household Debt When people fret about “over indebted” consumers, they’re likely referring to (in the US, at least) what the Federal Reserve defines as “Household Debt.” This includes home mortgages and consumer credit (shown in Figure 6.1). The vast majority of household debt is in home mortgages, which includes total outstanding mortgage

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loans and home equity lines of credit. The rest is consumer credit, which includes non-revolving (automobile loans, student loans) and revolving debt (credit cards, primarily). Home mortgages are an example of debt that is both a bridge between current expenses and future income as well as an investment arbitrage. Were it not for credit—mortgages, in this case—homebuyers would need to save the entire cost of a home before buying. This is prohibitive for all but the wealthiest households— bridging the gap between today’s expenses (the value of the home) and tomorrow’s income allows homes to be bought and sold regularly. Credit can also provide an investment arbitrage if you use your borrowed funds to purchase an asset that appreciates at a higher rate than that of your debt—if your house is appreciating at 10 percent a year and the rate on your mortgage is 5.5 percent, the spread between the two is your gain. However, the majority of purchases funded by consumer credit are not for appreciating assets. (Baseball card collectors and philatelists may quibble over this, but generally, credit cards aren’t normally used to buy large-ticket appreciating assets.)

1.0% 0.9% 18.9%

79.2% Mortgage Debt Consumer Credit

Figure 6.1

Bank Loans Other Loans and Advances

Breakdown of Outstanding Household Debt

Source: US Federal Reserve, as of 9/17/2009.

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think. As short-term credit markets froze and companies were unable to finance their operations, the economy slowed and jobs were eliminated in the process. While many concluded consumers stopped spending in response to reduced credit limits and frozen lines of credit, it was unemployment that drove things lower, not lack of credit access. We’ll describe credit’s impact on consumer spending in more detail later on in this chapter. The Real Estate “Wealth Effect”

A popular theory in recent years is the real estate “wealth effect”—the idea that home equity gains boost consumers’ real wealth and consequently increase spending. While home value does have some impact, it’s simply less than the “wealth effect” proponents would think. Certainly, spending did increase during the 1990s and early 2000s alongside home value increases. But the two were far likelier coincident, not causal. We know this because though home values began to erode in 2007 and 2008, consumer spending continued to rise. And while home values really imploded through 2008 into 2009, consumer spending stayed relatively firm—and far more closely tied to disposable income. Figure 6.2 graphs disposable income and home equity alongside consumer spending going back to 1970. As you can see, disposable income and consumer spending have a very close relationship, while growth in home equity failed to impact spending when it spiked up heading into 2006 and when it plummeted shortly thereafter. Maybe some consumption can be driven by the availability of mortgages, but the reality is it’s not much. In the US, interest payments on mortgage debt are tax deductible, and the long-term spread between borrowing costs and home appreciation can be a tailwind to personal net worth. In the case of consumer credit, bridging expenses and income is not a material spending driver either, as today’s debtfinanced spending must be repaid in the future at the expense of additional consumption.

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$16.0 Consumer Spending

Disposable Income

Home Equity

$14.0 Home equity rises and falls dramatically with minimal impact on disposable income OR spending!

US Dollars, Trillions

$12.0 $10.0 $8.0 $6.0 $4.0 $2.0

Figure 6.2

2008

2004

2000

1996

1992

1988

1984

1980

1976

1972

1968

1964

1960

1956

1952

$0.0

Disposable Income, Not Home Equity

Source: Thomson Reuters.

Your Home Is NOT an ATM

Another popular media headline in 2007 and 2008 was bemoaning those “profligate” consumers who had maxed themselves out and were using home equity to drive purchases—using their homes as the proverbial ATM. While a captivating narrative, there is little evidence such behavior was widespread or responsible for much actual consumer spending. Equity is harvested from one’s home via Mortgage Equity Withdrawals (“MEWs”), which come in three forms. The first and most common is the capital gain generated by the sale of a home. It is simply the amount you received for the house less any mortgage and closing fees. The other types, cash out refinancing and home equity lines of credit, are similar and allow a homeowner to borrow against existing equity in the home. If MEW is driving consumer spending, we should observe a strong relationship between home equity and spending, or at least

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Cash Out Refinancing and Home Equity Lines of Credit Both cash out refinancing and home equity lines of credit allow homeowners to spend unrealized home equity. For example, say Mr. Heauxmoner has a $450,000 home with $75,000 remaining on the mortgage and $375,000 in home equity. If interest rates have come down since he originally financed his mortgage, Mr. Heauxmoner may want to refinance the remaining $75,000 due on his mortgage. However, if Mr. Heauxmoner borrows more than the $75,000 he owes and uses the proceeds for something other than reducing his mortgage debt, he has effectively cashed out a portion of his home equity. Home equity lines of credit simply allow homeowners to borrow against home equity without refinancing the remaining mortgage balance.

between MEW and consumer spending. However, as we pointed out in Figure 6.2, the relationship between consumer spending and home equity gains is tenuous at best. Funds from MEW are used primarily to reinvest in another home (not included as part of consumer spending). Indeed, 90 percent of transaction capital gains are reinvested in another home, while less than 30 percent of funds from cash out refinancing and home equity lines of credit are used to fund additional consumption.1 The majority of these funds are used to pay down other non-mortgage debt like credit cards or auto loans. Most damning, from 1991 to 2005, funds from MEW averaged 1 percent of annual consumer spending. A more liberal calculation would include the MEW directed toward reducing non-mortgage debt, as one could argue that debt was likely incurred to finance consumption. Including non-housing debt payments, MEW averaged 1.7 percent of annual consumer spending from 1991 to 2005.2 Homes are hardly acting as a dominant source of spending power. Sometimes, Credit Just Ain’t Enough Home equity is only one part of the credit-fueled consumption story. Other types of debt, like personal lines of credit, auto loans, and credit cards, are also suggested as potential spending drivers. As the argument goes, when credit is

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easily available (defined by willingness of banks to lend), spending should grow as consumers finance consumption with debt. We concede that credit availability helps sales of big-ticket goods and services that might otherwise have been delayed if consumers had to save to pay in full, but reject the notion credit availability is a material spending driver in developed economies. Since 1966, the Federal Reserve has published the Senior Loan Officer Study (“SLOS”), which surveys loan officers at banks across the nation about whether they are more or less likely to lend this week versus last. Netting the “more likely” responses versus the “less likely” responses (and accounting for those that are unchanged) provides a way to measure credit availability. If credit availability is a driver of consumption, there should be a strong relationship between changes in the net SLOS survey and consumption. However, since 1966, a 10 percent change in credit availability translates into a 0.4 percent change in consumption. During recessions, the impact on spending increases to 1.3 percent.3 Since consumer spending percentage growth is typically measured in the low- to mid-single digits, this is a pretty meaningful relationship, right? Not exactly. Consider the following example. Loan officers open the lending floodgates and the SLOS survey shows a 10 percent increase in credit availability. Over the same period, consumer spending grows 1.5 percent versus the prior year. About 0.4 percent of the growth should be attributable to credit availability. However, the same conditions that support a healthy lending environment also support growth in consumer spending; namely, strong employment, wage growth, higher disposable income, and benign interest rates. Again, we grant credit access has some association with spending, but stop short of concluding a causal relationship and prefer to focus instead on the major consumption drivers we identified in Chapter 3. TREMENDOUS OPPORTUNITIES IN EMERGING MARKETS In America and other developed nations we take the easy availability of credit cards, auto loans, and mortgages for granted. But in some

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emerging markets, these can be relatively newer innovations and not as readily available to some. Consumer lending, though certainly more mature in some emerging markets, is still rare in some nations, thanks to less developed financial markets and unwillingness on the part of some banks to lend because of high interest rates and inflation. So why is an expansion of household debt an opportunity in emerging markets when it’s a relatively insignificant consumption driver in developed markets? Because in developed markets, anyone who can or would use credit already does. There are some marginal increases— kids turning 18, for example, can become a “new” credit card user—but not enough to move the needle much. In many emerging markets, steps by governments and central banks are driving an expansion in the number of households that can access and afford credit. Because increased access to credit allows more people in these regions to bridge current expenses and future income, consumer spending is increasing. It is true—in emerging markets and developed—that today’s debt-financed consumption comes at the expense of tomorrow’s spending. However, if only 100 consumers had credit cards, for example, and suddenly 400 can borrow, consumption increases. Similarly, the introduction of more widespread mortgage financing is providing consumers the opportunity for arbitrage described earlier in the chapter. When credit becomes available where previously there was none, the impact on consumption and economic activity can be dramatic. A great example of this is Brazil, where the confluence of financial innovation, falling interest rates, and economic growth are driving a tremendous expansion in the availability of credit and consumer spending. If other emerging markets follow its lead, the benefits to the global economy could be immense. CASE STUDY: BRAZIL’S CREDIT-DRIVEN CONSUMPTION BOOM A successful overhaul of a nation’s entire financial system is tricky business, frequently treacherous. But Brazil’s overhaul, with its frequent bumps and setbacks, has been largely successful. And the fact it’s

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evolved in just the last 15 years is nothing short of miraculous. By reining in runaway government spending, establishing an inflation target, and building the financial infrastructure to support a securitization market, credit is more accessible and affordable now than ever before, which should provide a lasting tailwind for consumer spending in Brazil. Taming Inflation

In the late 1980s and early 1990s, Brazil suffered from severe hyperinflation. Americans like to cry, “Inflation!” when gas prices tick up. And certainly many investors remember America’s high inflation from the 1970s and early 1980s. But even at its peak, America couldn’t really claim it was hyperinflation. Consider: From 1988 through 1994, inflation in Brazil averaged 1,677 percent per year. In 1990, inflation reached almost 6,000 percent.4 Figure 6.3 shows inflation in Brazil since 1980—with inflation that high, banks required astronomical interest rates on loans, all but prohibiting consumer lending.

7000% Annualized Brazilian CPI 6000%

Brazilian CPI

5000% 4000% 3000% 2000% 1000%

2008

2006

2004

2002

2000

1998

1996

1994

1992

1990

1988

1986

1984

1982

1980

0%

Figure 6.3 Brazilian National CPI Source: Thomson Reuters.

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It seemed an unbreakable cycle. Inefficient fiscal policy led to large deficits, which the government monetized. Monetizing debt means the government simply prints new money to pay its debts rather than borrowing new funds or using tax revenues. No value is created but the money supply increases, driving inflation. Existing laws indexed wages and consumer prices to inflation, resulting in “inertial inflation.” Several presidents tried to break the cycle through price and wage freezes; however, all failed to have a lasting impact. The result was inflation measured in the thousands of percents and minimal (if any) consumer lending. In 1994, Finance Minister Fernando Cardoso submitted the “Plan Real.” The plan was two-pronged. First, break the inertial inflation cycle; then get fiscal policy under control. Mr. Cardoso introduced a new currency, initially called the “unidade real de valor” or the “real.” The new currency was initially pegged to the US dollar but was subsequently allowed to float. Most were critical of the plan after several previous attempts to control inflation and stabilize the currency. At first, the real was quoted alongside the incumbent cruzeiro real. Slowly, salaries and prices were converted into the real. With its loose peg to the dollar, the real was more stable than the cruzeiro real, which continued to rapidly depreciate. Despite several attempts to destabilize the new currency by foreign investors betting Brazil would again fail to fix its monetary problems, the new real actually strengthened versus the dollar and helped Brazil attract foreign capital flows. With foreign investment flowing in, the government was able to pay its debts rather than print funny money. At the same time, Mr. Cardoso proposed the privatization of previously governmentowned businesses. He believed that outside of government control, these companies would operate more efficiently, maximizing profits and expanding the tax base. As inflation moderated, banks were able to begin lending at more affordable rates. Figure 6.4 shows how inflation fell after the implementation of the Plan Real. As inflation moderated, so too did lending rates. Figure 6.5 illustrates how falling interest rates boosted consumer

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3500% Annualized Brazilian CPI 3000% 2500%

Brazilian CPI

2000% 1500% 1000% 500%

Figure 6.4

Q3 1999

Q1 1999

Q3 1998

Q1 1998

Q3 1997

Q1 1997

Q3 1996

Q1 1996

Q3 1995

Q1 1995

⫺500%

Q3 1994

0%

Brazilian National CPI (mid-1994 to 2000)

Source: Thomson Reuters.

45,000 40,000

250% 35,000 200%

30,000 25,000

150% 20,000 100%

15,000

Lending Rates - Individuals

Credit Outstanding - Individuals (Billions of R$)

300%

Credit Outstanding - Individuals Lending Rates - Individuals

10,000 50% 5,000 0% 1999

1998

1997

1996

1995

1994

0

Figure 6.5 Individual Lending Rates and Amounts Outstanding Source: Thomson Reuters.

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lending. Though much improved, the consumer lending environment was still in its infancy. Still, the impact of lower inflation on consumers was dramatic, especially for the low and middle class. Low-income households were often unable to meet minimum account balances to open savings accounts, which at the time were also indexed to inflation, providing a natural hedge for those wealthy enough to meet the minimums. With inflation coming under control, the wages and spending power of low-income households were no longer immediately eroded by rapid inflation. While initially unpopular, the success of the Plan Real helped Mr. Cardoso win the presidency just one year later. Five years later, President Cardoso implemented inflation targeting as the official monetary policy of the central bank. Inflation targeting is largely a credibility exercise—the central bank is communicating with the market to provide clarity into its interest rate decisions. In doing so, lending risk is diminished as banks demand a lower risk premium on loans, making borrowing more affordable. Around the same time, Cardoso passed the Fiscal Responsibility Law, placing clear limits on government spending and its ability to borrow. After years of rampant deficit spending, this was a welcome change. The combination of currency stabilization, inflation targeting, and fiscal restraint resulted in a reduction in overnight and bank lending rates, increasing the ability of banks to lend. Liquidity, Liquidity, and More Liquidity

Taming inflation was just the start of Brazil’s credit revolution. The real estate finance system, introduced in 1997, established primary and secondary markets for the securitization of real estate loans. By securitizing real estate receivables, lenders are able to accelerate lending without incurring additional debt or waiting to recoup the lent funds. Also, because the lender is no longer exposed to default risk on the original loan, it can afford to offer lower interest rates to potential borrowers. It took a few years for securitization to catch on as investors familiarized themselves with the terms and functions of the securitization

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Securitization: A Way to Reduce Risk and Increase Liquidity Although vilified in the aftermath of the late 2008/early 2009 bear market, securitization is not the bogey man media pundits make it out to be. Securitization is financial intermediation at its best. Let’s say the lending arm of Chapter 5’s imaginary automaker Fion Motors—Fion Motors Acceptance Corp. (FMAC)—provides an auto loan to Joe Consumer. Over the next five years, FMAC collects monthly payments from Joe Consumer. The money it originally lent out will not be recouped for years. However, through securitization, FMAC can sell notes to a third party, which entitle the third party to the cash flows from the original FMAC loan in return for a lump sum payment to FMAC. FMAC is then free to lend out that money again rather than wait to collect the payments from its initial loan.

Credit Outstanding - Individuals (Billions of R$)

450,000 Brazilian Credit Outstanding - Individuals 400,000 350,000 300,000

Brazil creates the Receivables Investment Fund in late 2001

25.3% annualized growth rate

250,000 200,000 150,000

23.1% annualized growth rate

100,000 50,000

2008

2007

2006

2005

2004

2003

2002

2001

2000

1999

1998

1997

0

Figure 6.6 Credit Outstanding to Individual Borrowers, 1997 to 2008 Source: Thomson Reuters.

markets. As securitizations picked up in 2000 and 2001, Brazil’s central bank created the Receivables Investment Fund, allowing securitization of nearly all forms of receivables. Receivables from personal loans, corporate trade accounts, auto loans, government obligations, utilities services, student loans, and many others were allowed to be securitized. Figure 6.6 shows how the rule change in late 2001 accelerated lending

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growth to individuals above the rates achieved by the original 1997 legalization of real estate receivables. To offset potential sentiment-driven credit tightening in the aftermath of the late 2008/early 2009 financial turmoil, Brazil’s central bank boosted liquidity again—this time by reducing required bank reserve ratios to 42 percent from 45 percent. The combination of a relatively stable currency (versus its historic volatility), manageable inflation, lower interest rates, developing securitization markets, and eased restrictions on reserve requirements have combined to drive a massive expansion in credit availability to Brazilian consumers and businesses alike. Credit’s Impact on Consumer Spending

While we don’t expect consumers to use credit in a materially different fashion in Brazil than in the US (insofar as credit is a bridge between current expenses and future income as well as a tool for arbitrage), the number of households able to use credit in the first place is expanding. This, in turn, increases overall spending. Indeed, through 2008, consumer spending has grown an annualized 11.1 percent since the end of 1997, when the securitization market was created.5 The expansion of the securitization market in 2001 resulted in an acceleration in annualized consumer spending growth, boosting the annual rate to 11.5 percent through 2008.6 Figure 6.7 illustrates the different growth rates. What’s impressive about this sort of growth is that it so handily outpaces growth in the broader Brazilian economy. Over time, growth in spending and overall GDP should be relatively similar, considering one drives the other in a chicken-and-the-egg relationship. While GDP growth drives consumer spending, the impact of expanding credit availability cannot be overlooked. Indeed, comparing the annualized growth rates of consumer spending and GDP over the same periods we evaluated previously (from 1997 through 2008, from 1997 through 2001, and from 2001 through 2008), growth in consumer spending has outpaced growth in GDP by 7.8 percent, 7.5 percent, and

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Household Debt—Myths and Opportunities 1,800,000

Consumer Spending (Billions of R$)

1,600,000

1,200,000 1,000,000

Since the Receivables Investment Fund was created, consumer spending accelerated to a 11.5% annualized growth

Creation of the Receivables Investment Fund in late 2001

1,400,000

125

After securitization was legalized in 1997, consumer spending grew at a 9.5% annualized rate

800,000 600,000 400,000 200,000

2008

2007

2006

2005

2004

2003

2002

2001

2000

1999

1998

0

Consumer Spending (Billions of R$)

Figure 6.7 Brazilian Consumer Spending Growth Source: Thomson Reuters.

9.0 percent, respectively. Expansion in credit availability and affordability is clearly having an impact. Opportunities Emerge

In the last 15 years, Brazil has developed into an emerging market economic powerhouse. Export demand for its abundant natural resources is now supplemented by a consumer population with growing income and expanding access to credit. The steps Brazil took were not always popular and certainly not easy. However, what the Brazilians accomplished can be replicated elsewhere. With few exceptions—like South Korea, for instance—financial markets in developing economies are nowhere near as developed as Brazil’s. If governments in emerging markets follow Brazil’s lead, the impact on economic growth could be enormous, boosting disposable income and consumption—and possibly be tremendously beneficial to the Consumer Discretionary sector.

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Chapter Recap Credit is not a material spending driver in developed markets; however, it provides a valuable service. • Credit serves two ends: bridging the gap between current expenses and future income; and providing an arbitrage between borrowing costs and return on investment. • Gains in home equity are usually reinvested in another home or used to reduce non-mortgage debt. • Most consumer credit is eventually paid back at the expense of future spending. • Credit in emerging markets can boost consumption since credit markets are under developed and have low market penetration. • Countries like Brazil—where lending was nearly non-existent due to a legacy of out-of-control inflation, volatile currency, crushing deficits, and high interest rates—are examples of how emerging economies can foster the use of credit. • Expanding credit markets are driving gains in consumer spending as more households are able to access credit, and the availability of mortgages is supporting investment arbitrage.

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III THINKING LIKE A PORTFOLIO MANAGER

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7 THE TOP-DOWN METHOD

S

o if you’re bullish on Consumer Discretionary, how much of your portfolio should you put in Consumer Discretionary stocks? Twenty-five percent? Fifty? One hundred percent? This question concerns portfolio management. Most investors concern themselves only with individual companies (“I like JC Penney, so I’ll buy some”), without considering how it fits into their overall portfolio. But this is no way to manage your money. In this part of the book, we show you how to analyze Consumer Discretionary companies like a top-down portfolio manager. This includes a full description of the top-down method, how to use benchmarks, and how the top-down method applies to the Consumer Discretionary sector. We then delve into security analysis in Chapter 8, where we provide a framework for analyzing any company and discuss many of the important questions to ask when analyzing Consumer Discretionary companies. Finally, in Chapter 9, we conclude by giving a few examples of specific investing strategies for the Consumer Discretionary sector. 129

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INVESTING IS A SCIENCE Too many investors today think investing has “rules”—that all one must do to succeed in investing for the long run is find the right set of investing rules. But that simply doesn’t work. Why? All well-known and widely discussed information is already reflected in stock prices. This is a basic tenet of market theory and commonly referred to as “market efficiency.” So if you see a headline about a stock you follow, there’s no use trading on that information—it’s already priced in. You missed the move. If everything known is already discounted in prices, the only way to consistently beat the market is to know something others don’t. Think about it: There are many intelligent investors and longtime professionals who fail to beat the market year after year, most with the same access to information as anyone, if not more. Why? Most view investing as a craft. They think, “If I learn the craft of value investing and all its rules, then I can be a successful investor using that method.” But that simply can’t work because, by definition, all the conventional ways of thinking about value investing will already be widely known and thus priced in. In fact, most investment styles are very well-known and already widely practiced. There are undoubtedly millions of investors out there much like you, looking at the same metrics and information you are. So there isn’t much power in them. Even the investing techniques themselves are widely known—taught to millions in universities and practiced by hundreds of thousands of professionals globally. There’s no edge. Moreover, it’s been demonstrated investment styles move in and out of favor over time—no one style or category is inherently better than another in the long run. You may think “value” investing works wonders to beat markets, but the fact is growth stocks will trounce value at times. The key to beating stock markets lies in being dynamic—never adhering for all time to a single investment idea—and gleaning information the market hasn’t yet priced in. In other words, you cannot adhere to a single set of “rules” and hope to outperform markets over time.

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So how can you beat the markets? By thinking of investing as a science. EINSTEIN’S BRAIN AND THE STOCK MARKET If he weren’t so busy becoming the most renowned scientist of the twentieth century, Albert Einstein would have made a killing on Wall Street—but not because he had such a high IQ. Granted, he was immensely intelligent, but a high IQ alone does not make a market guru. (If it did, MIT professors would be making millions managing money instead of teaching.) Instead, it’s the style of his thought and the method of his work that matter. In the little we know about Einstein’s investment track record, he didn’t do very well. He lost most of his Nobel Prize money in bad bond ventures.1 Heck, Sir Isaac Newton may have given us the three laws of motion, but even his talents didn’t extend to investing. He lost his shirt in the South Sea Bubble of the early 1700s, explaining later, “I can calculate the movement of the stars, but not the madness of men.” So why believe Einstein would have been a great portfolio manager if he put his mind to it? In short, Einstein was a true and highly creative scientist. He didn’t take the acknowledged rules of physics as such—he used prior knowledge, logic, and creativity, combined with the rigors of the verifiable, testable scientific method, to create an entirely new view of the cosmos. In other words, he was dynamic and gleaned knowledge others didn’t have. Investors should do the same. (Not to worry, you won’t need advanced calculus to do it.) Einstein’s unique character gave him an edge—he truly had a mind made to beat markets. Scientists have studied his work, his speeches, his letters, even his brain (literally) to find the secret of his intellect. In all, his approach to information processing and idea generation, his willingness to go against the grain of the establishment, and his relentless pursuit of answers to questions no one else was asking ultimately made him a genius. Both his contemporaries and most biographers agree one of Einstein’s foremost gifts was his ability to discern “the big picture.”

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Unlike many scientists who could easily drown themselves in data minutiae, Einstein had an ability to see above the fray. Another way to say this is he could take the same information everyone else at his time was looking at and interpret it differently, yet correctly. He accomplished this using his talent for extracting the most important data from what he studied and linking them together in innovative ways no one else could. Einstein called this “combinatory play.” Similar to a child experimenting with a new Lego set, Einstein would combine and recombine seemingly unrelated ideas, concepts, and images to produce new, original discoveries. In the end, most new ideas are merely the combination of existing ones in one form or another. Take E ⫽ mc 2—Einstein was not the first to discover the concepts of energy, mass, or the speed of light; rather, he combined these concepts in a novel way and, in the process, altered the way in which we view the universe.2 Einstein’s combinatory play is a terrific metaphor for stock investing. To be a successful market strategist, you must be able to extract the most important data from all of the “noise” permeating today’s markets and generate conclusions the market hasn’t yet appreciated. Central to this task is your ability to link data together in unique ways and produce new insights and themes for your portfolio in the process. Einstein learned science basics just like his peers. But once he had those mastered, he directed his brain to challenging prior assumptions and inventing entirely different lenses to look through. This is why this book isn’t intended to give you a “silver bullet” for picking the right Consumer Discretionary stocks. The fact is the “right” Consumer Discretionary stocks will be different in different times and situations. You don’t have to be Einstein, you just need to think differently. THE TOP-DOWN METHOD Overwhelmingly, investment professionals today do what can broadly be labeled “bottom-up” investing. Their emphasis is on stock selection. A typical bottom-up investor researches an assortment of companies and

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attempts to pick those with the greatest likelihood of outperforming the market based on individual merits. The selected securities are cobbled together to form a portfolio, and factors like country and sector exposure are purely residuals of security selection, not planned decisions. “Top-down” investing reverses the order. A top-down investor first analyzes big-picture factors like economics, politics, and sentiment to forecast which investment categories are most likely to outperform the market. Only then does a top-down investor begin looking at individual securities. Top-down investing is inevitably more concerned with a portfolio’s aggregate exposure to investment categories than with any individual security. Thus, top-down is an inherently dynamic mode of investment because investment strategies are based upon the prevailing market and economic environment (which changes often). There’s significant debate in the investment community as to which approach is superior. This book’s goal is not to reject bottomup investing—there are indeed investors who’ve successfully utilized bottom-up approaches. Rather, the goal is to introduce a comprehensive and flexible methodology that any investor could use to build a portfolio designed to beat the global stock market in any investment environment. It’s a framework for gleaning new insights and making good on information not already reflected in stock prices. Before we describe the method, let’s explore several key reasons why a top-down approach is advantageous: • Scalability: A bottom-up process is akin to looking for needles in a haystack. A top-down process is akin to seeking the haystacks with the highest concentration of needles. Globally, there are nearly 25,000 publicly traded stocks investors can easily buy. Even the largest institutions with the greatest research resources cannot hope to adequately examine all these companies. Smaller institutions and individual investors must prioritize where to focus their limited resources. Unlike a bottom-up process, a top-down process makes this gargantuan task manageable by determining, up front, what slices of the market to examine at the security level.

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• Enhanced stock selection: Well-designed top-down processes generate insights that can greatly enhance stock selection. Macroeconomic or political analysis, for instance, can help determine what types of strategic attributes will face head or tailwinds (see Chapter 8 for a full explanation). • Risk control: Bottom-up processes are highly subject to unintended risk concentrations. Top-down processes are inherently better suited to manage risk exposures throughout the investment process. • Macro overview: Top-down processes are more conducive to avoiding macro-driven calamities like the bursting of the Japan bubble in the 1990s, the Technology bubble in 2000, or the bear market of 2000 to 2002. No matter how good an individual company may be, it is still beholden to sector, regional, and broad market factors. In fact, there is evidence “macro” factors can largely determine a stock’s performance regardless of individual merit. Top Down Means Thinking 70-20-10

A top-down investment process also helps focus on what’s most important to investment results: asset and sub-asset allocation decisions. Many investors focus most of their attention on security-level portfolio decisions, like picking individual stocks they think will perform well. However, studies have shown that over 90 percent of return variability is derived from asset allocation decisions, not market timing or stock selection.3 Our research shows about 70 percent of return variability is derived from asset allocation, 20 percent from sub-asset allocation (such as country, sector, size, and style), and 10 percent from security selection. While security selection can make a significant difference over time, higherlevel portfolio decisions dominate investment results more often than not. The balance of this chapter defines the various steps in the topdown method, specifically as they relate to making country, sector, and style decisions. This same basic framework can be applied to

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portfolios to make allocations within sectors. At the end of the chapter, we detail how this framework can be applied to the Consumer Discretionary sector. Benchmarks

A key part of the top-down model is using benchmarks. A benchmark is typically a broad-based index of securities such as the S&P 500, MSCI World, or Russell 2000. Benchmarks are indispensible road maps for structuring a portfolio, monitoring risk, and judging performance over time. Tactically, a portfolio should be structured to maximize the probability of consistently beating the benchmark. This is inherently different than maximizing returns. Unlike aiming to achieve some fixed rate of return each year, which will cause disappointment relative to peers when capital markets are very strong and is potentially unrealistic when the capital markets are very weak, a properly benchmarked portfolio provides a realistic guide for dealing with uncertain market conditions. Portfolio construction begins by evaluating the characteristics of the chosen benchmark: sector weights, country weights, and market cap Table 7.1 MSCI World Characteristics: Sectors Sector

Weight

Financials

19.7%

Information Technology

11.7%

Energy

11.4%

Health Care

10.7%

Consumer Staples

10.5%

Industrials

10.3%

Consumer Discretionary

9.3%

Materials

6.8%

Utilities

5.0%

Telecommunication Services

4.6%

Source: Thomson Reuters; MSCI, Inc.4 as of 6/30/2009.

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Table 7.2 MSCI World Characteristics: Countries Country

Weight

US

48.5%

Japan

11.3%

UK

9.8%

France

4.8%

Canada

4.7%

Germany

3.6%

Switzerland

3.5%

Australia

3.5%

Spain

2.1%

Italy

1.7%

Hong Kong

1.1%

Sweden

1.1%

Netherlands

1.1%

Singapore

0.6%

Finland

0.6%

Denmark

0.4%

Belgium

0.4%

Norway

0.3%

Greece

0.3%

Portugal

0.2%

Austria

0.1%

Ireland

0.1%

New Zealand

0.0%

Emerging Markets

0.0%

Source: Thomson Reuters; MSCI, Inc.5 as of 6/30/2009.

and valuations. Then an expected risk and return is assigned to each of these segments (based on portfolio drivers), and the most attractive areas are overweighted, while the least attractive are underweighted. Table 7.1 shows MSCI World benchmark sector characteristics as of June 30, 2009, as an example, while Table 7.2 shows country characteristics, and Table 7.3 shows market cap and valuations.

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Table 7.3 MSCI World Characteristics: Market Cap and Valuations Valuations Median Market Cap

$ 5.4B

Weighted Average Market Cap

$53.3B

P/E

12.3

P/B

1.8

Dividend Yield

3.0

P/CF

8.9

P/S

1.7

Number of Holdings

1,656

Notes: P/E = price-to-earnings ratio; P/B = price-to-book ratio; P/CF = price-to-cash-flow ratio; P/S = price-to-sales ratio. Source: Thomson Reuters; MSCI, Inc.6 as of 6/30/2009.

Based on benchmark characteristics, portfolio drivers are then used to determine country, sector, and style decisions for the portfolio. For example, in Table 7.1 the Financials sector weight of the MSCI World Index is about 20 percent. Therefore, a portfolio managed against this benchmark would consider a 20 percent weight in Financials “neutral,” or market-weighted. If you believe Financials will perform better than the market in the foreseeable future, then you would “overweight” the sector, or hold more than 20 percent of your portfolio in Financials stocks. The reverse is true for an “underweight”—you’d hold less than 20 percent in Financials if you were pessimistic on the sector looking ahead. Note that being pessimistic on Financials doesn’t necessarily mean holding zero financial stocks. It might only mean holding a lesser percentage of stocks in your portfolio than the benchmark. This is an important feature of benchmarking—it allows an investor to make strategic decisions on sectors and countries, but maintains diversification, thus managing risk more appropriately. For the Consumer Discretionary sector, we can use Consumer Discretionary–specific benchmarks like the S&P 500 Consumer Discretionary, MSCI ACWI Consumer Discretionary, or Russell 2000

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Consumer Discretionary indexes. The components of these benchmarks can then be evaluated at a more detailed level such as industry and sub-industry weights. (For example, we broke out MSCI ACWI industry and sub-industry benchmark weights in Chapter 4.) TOP DOWN DECONSTRUCTED The top-down method begins by first analyzing the macro environment. It asks the “big” questions like: Do you think stocks will go up or down in the next 12 months? If so, which countries or sectors should benefit most? Once you have decided on these high-level portfolio “drivers” (sometimes called “themes”), you can examine various macro-portfolio drivers to make general overweight and underweight decisions for countries, sectors, industries, and sub-industries versus your benchmark. For instance, let’s say we’ve determined a macroeconomic driver that goes something like this: “In the next 12 months, I believe global consumer spending will be greater than most expect.” That’s a very high-level statement with important implications for your portfolio. It means you’d want to search for industries, and ultimately stocks, that would benefit most from increasing consumer spending. The second step in top-down is applying quantitative screening criteria to narrow the choice set of stocks. Since, in our hypothetical example, we believe consumer spending will be high, it likely means we’re bullish on Retailing stocks. But which ones? Are you bullish on, say, home improvement retailers? Consumer electronics retailers? Automotive retailers? Do you want producers with exposure to the US or another region? Do you want small-cap Consumer Discretionary companies or large cap? And what about valuations? Are you looking for growth or value? (Size and growth/value categories are often referred to as “style” decisions.) These criteria and more can help you narrow the list of stocks you might buy. The third and final step is performing fundamental analysis on individual stocks. Notice that a great deal of thinking, analysis, and work is done before you ever think about individual stocks. That’s the key to the top-down approach: It emphasizes high-level themes and funnels its way down to individual stocks, as is illustrated in Figure 7.1.

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Portfolio Drivers Economic, Political, Sentiment Step 1

Country and Sector Selection

Step 2

Quantitative Factor Screening Liquidity Solvency Valuation Capitalization

Step 3

Stock Selection Fundamental analysis Outlier analysis Strategic attributes

Portfolio

Figure 7.1

Portfolio Drivers

Step 1: Analyze Portfolio Drivers and Country and Sector Selection

Let’s examine the first step in the top-down method more closely. In order to make top-down decisions, we develop and analyze what we call portfolio drivers (as mentioned previously). We segment these portfolio drivers in three general categories: economic, political, and sentiment. Portfolio drivers are what drive the performance of a broad category of stocks. Accurately identifying current and future drivers will help you find areas of the market most likely to outperform or underperform your benchmark (i.e., the broader stock market). Table 7.4 shows examples of each type of portfolio driver. It’s important to note these drivers are by no means comprehensive nor are they valid for all time periods. In fact, correctly identifying new portfolio drivers is essential to beating the market in the long term.

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Table 7.4 Portfolio Drivers Economic

Political

Sentiment

Yield Curve Spread

Taxation

Mutual fund flows

Relative GDP growth

Property rights

Relative style and asset class valuations

Monetary base/growth

Structural reform

Media coverage

Currency strength

Privatization

Institutional searches

Relative interest rates

Trade/capital barriers

Consumer confidence

Inflation

Current account

Foreign investment

Debt level (sovereign, corporate, consumer)

Government stability

Professional investor forecasts

Infrastructure spending

Political turnover

Momentum cycle analysis

M&A, issuance, and repurchase activity

Wars/conflicts

Risk aversion

Economic Drivers Economic drivers are anything related to the

macroeconomic environment. This could include monetary policy, interest rates, lending activity, yield curve analysis, relative GDP growth analysis, and myriad others. What economic forces are likely to drive GDP growth throughout countries in the world? What is the outlook for interest rates and how would that impact sectors? What is the outlook for technology and infrastructure spending among countries? Economic drivers pertain not only to the fundamental outlook of the economy (GDP growth, interest rates, inflation), but also to the stock market (valuations, M&A activity, share buybacks). As an investor, it’s your job to identify these drivers and determine how they’ll impact your overall portfolio and each of its segments. The following is an example list of economic drivers that could impact portfolio performance: • • • •

US economic growth will be higher than consensus expectations. European Union interest rates will remain benign. Mergers, acquisitions, and share buybacks will remain strong. Emerging markets growth will drive commodity demand.

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Political Drivers Political drivers can be country specific, pertain to regions (European Union, Organisation for Economic Cooperation and Development [OECD]), or affect interaction between countries or regions (such as trade policies). These drivers are more concerned with categories such as taxation, government stability, fiscal policy, and political turnover. Which countries are experiencing a change in government that could have a meaningful impact on their economies? Which sectors could be at risk from new taxation or legislation? Which countries are undergoing pro-growth reforms? Political drivers will help determine the relative attractiveness of market segments and countries based on the outlook for the political environment. Be warned, however: Most investors suffer from “home country bias,” where they ascribe too much emphasis on the politics of their own country. Always keep in mind it’s a big, interconnected world out there, and geopolitical developments everywhere can have implications. What are possible political drivers you can find? The following is a list of examples that can drive stocks up or down.

• Political party change in Japan driving pro-growth reforms. • New tax policies in Germany stalling economic growth. • Protests, government coups, conflict driving political instability in Thailand. Sentiment Drivers Sentiment drivers attempt to measure consensus

thinking about investment categories. Ideally, drivers identify market opportunities where sentiment is different than reality. For example, let’s say you observe current broad market sentiment expects a US recession in the next year. But you disagree and believe GDP growth will be strong. This presents an excellent opportunity for excess returns. You can load up on stocks that will benefit from an economic boom and watch the prices rise as the rest of the market realizes it much later. Since the market is a discounter of all known information, it’s important to try and identify what the market is pricing in. The interpretation of such investor drivers is typically counterintuitive (avoid what is overly popular and seek what is largely unpopular). Looking forward,

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which sectors are investors most bullish about and why? What countries or sectors are widely discussed in the media? What market segments have been bid up recently based on something other than fundamentals? If the market’s perception is different than fundamentals in the short term, stocks will eventually correct themselves to reflect reality in the long term. A note of caution: Gauging market sentiment does not mean being a contrarian. Contrarians are investors who simply do the opposite of what most believe will happen. Instead, find places where sentiment (people’s beliefs) doesn’t match what you believe is reality and over- or underweight sections of your portfolio accordingly, relative to your benchmark. Examples of sentiment drivers include: • Investors remain pessimistic about Technology despite improving fundamentals. • Sentiment for the Chinese stock market approaches euphoria, stretching valuations. • Professional investors universally forecast US small-cap stocks to outperform. How to Create Your Own Investment Drivers In order to form your own investment drivers, the first step is accessing a wide array of data from multiple sources. For country drivers, this could range from globally focused publications like the Wall Street Journal or Financial Times to regional newspapers or government data. For sector drivers, this could include reading trade publications or following major company announcements. Remember, however, that markets are efficient—they reflect all widely known information. Most pertinent information about public companies is, well, public. Which means the market already knows. News travels fast, and investors with the knowledge and expectations are absorbed by markets very quickly. Those seeking to profit on a bit of news, rumor, or speculation must acknowledge the market will probably move faster than they can. Therefore, in order to consistently generate excess returns, you must either know something others don’t or interpret widely known information differently and correctly from the crowd. (For a detailed discussion on these factors and more, read The Only Three Questions That Count by Ken Fisher.)

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Step 2: Quantitative Factor Screening

Step two in the top-down method is screening for quantitative factors. This allows you to narrow the potential list of stocks once your portfolio drivers are in place. There are thousands and thousands of stocks out there, so it’s vital to use a series of factors like market capitalization and valuations to narrow the field a bit. Securities passing this screen are then subjected to further quantitative analysis that eliminates companies with excessive risk profiles relative to their peer group, such as companies with excessive leverage or balance sheet risk and securities lacking sufficient liquidity for investment. The rigidity of the quantitative screens is entirely up to you and will determine the number of companies on your prospect list. The more rigid the criteria, the fewer the companies that make the list. Broader criteria will increase the number of companies. Examples How can you perform such a screen? Here are two exam-

ples of quantitative factor screenings to show how broad or specific you can be. You might want to apply very strict criteria, or you may prefer to be broader. Strict Criteria

• First, you decide you want to search for only Consumer Discretionary firms. By definition, that excludes all companies from the other nine sectors. Already, you’ve narrowed the field a lot! • Now, let’s say that based on your high-level drivers, you only want Japanese Consumer Discretionary stocks. By excluding all other regions besides Japan, you’ve narrowed the field even more. • Next, let’s decide to search only for retail firms in the Consumer Discretionary sector. • Perhaps you don’t believe very small stocks are preferable, so you limit market capitalization to $5 billion and above.

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• Last, let’s set some parameters for valuation: • P/E (price-to-earnings) less than 12 • P/B (price-to-book) less than 8 • P/CF (price-to-cash-flow) less than 10 • P/S (price-to-sales) less than 6 This rigorous process of selecting parameters will yield a small number of stocks to research, all based on your higher-level themes. But maybe you have reason to be less specific and want to do a broader screen because you think Consumer Discretionary in general is a good place to be. Broad Criteria

• Consumer Discretionary sector • Global (no country or region restrictions) • Market caps above $10 billion This selection process is much broader and obviously gives you a much longer list of stocks to choose from. Doing either a strict or broad screen isn’t inherently better. It just depends on how well-formed and specific your higher-level themes are. Obviously, a stricter screen means less work for you in step three—actual stock selection. Step 3: Stock Selection

After narrowing the prospect list, your final step is identifying individual securities possessing strategic attributes consistent with higher-level portfolio themes. (We’ll cover the stock selection process specifically in more detail in Chapter 8.) Your stock selection process should attempt to accomplish two goals: 1. Find firms possessing strategic attributes consistent with higherlevel portfolio themes, derived from the drivers that give those firms a competitive advantage versus their peers. For example, if you believe owning firms with dominant market shares in consolidating industries is a favorable characteristic, you would search for firms with that profile.

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2. Maximize the likelihood of beating the category of stocks you are analyzing. For example, if you want a certain portfolio weight of Cable & Satellite companies and need 4 stocks out of 12 meeting the quantitative criteria, you then pick the 4 that, as a group, maximize the likelihood of beating all 12 as a whole. This is different than trying to pick “the best four.” By avoiding stocks likely to be extreme or “weird” outliers versus the group, you can reduce portfolio risk while adding value at the security selection level. In lieu of picking individual securities, there are other ways to exploit high-level themes in the top-down process. For instance, if you feel strongly about a particular sub-industry but don’t think you can add value through individual security analysis, it may be more prudent to buy a group of companies in the sub-industry or a category product like an exchange-traded fund (ETF). There are a growing variety of ETFs that track the domestic and global Consumer Discretionary sector, industries, and even specific commodity prices. This way, you can be sure to gain broad Consumer Discretionary exposure without much stock-specific risk. (For more information on ETFs, visit www .ishares.com, www.sectorspdr.com, or www.masterdata.com.) MANAGING AGAINST A CONSUMER DISCRETIONARY BENCHMARK Now we can practice translating this specifically to your Consumer Discretionary allocation. Just as you analyze the components of your benchmark to determine country and sector components in a topdown strategy, you must analyze each sector’s components, as we did in Chapter 4. To demonstrate how, we’ll use the MSCI World Consumer Discretionary Sector Index as the benchmark. Table 7.5 shows the MSCI World Consumer Discretionary industry weights as of June 30, 2009. We don’t know what the sample portfolio weights should be, but we know it should add up to 100 percent. Of course, if managing against a broader benchmark, your Consumer Discretionary sector weight may add up to more or less than the Consumer Discretionary weight in the benchmark, depending on over- or underweight decisions.

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Table 7.5 MSCI World Consumer Discretionary Industry Weights vs. Sample Portfolio Industry

MSCI World (%)

Sample Portfolio

Media

22.5%

?

Automobiles

19.5%

?

Specialty Retail

14.7%

?

Hotels, Restaurants & Leisure

11.9%

?

Household Durables

7.2%

?

Textiles, Apparels & Luxury Goods

6.4%

?

Multiline Retail

6.1%

?

Auto Components

4.7%

?

Internet & Catalogue Retail

2.9%

?

Leisure Equipment & Products

1.6%

?

Diversified Consumer Services

1.6%

?

Distributors

0.8%

?

Total

100.0%

100.0%

7

Source: Thomson Reuters; MSCI, Inc. as of 6/30/2009.

Keeping the industry weights in mind will help mitigate benchmark risk. If you have a portfolio of stocks with the same industry weights as the MSCI World Consumer Discretionary Index, you’re neutral—taking no benchmark risk. However, if you feel strongly about an industry, like Leisure Equipment & Products, and decide to only purchase those firms (one of the smallest weights in the sector), you’re taking a huge benchmark risk. The same is true if you significantly underweight an industry. All the same rules apply as when you do this from a broader portfolio perspective, as we did earlier in this chapter. The benchmark’s industry weights provide a jumping-off point in making further portfolio decisions. Once you make higher-level decisions on the industries, you can make choices versus the benchmark by overweighting the industries you feel likeliest to perform best and underweighting those likeliest to perform worst. Table 7.6 shows how you can make different portfolio bets against the benchmark by over- and underweighting industries.

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Table 7.6 Portfolio A Industry

MSCI World (%)

Portfolio A

Media

22.5%

27.5%

5.0%

Automobiles

19.5%

11.3%

–8.2%

Specialty Retail

14.7%

17.5%

2.8%

Hotels, Restaurants & Leisure

11.9%

15.9%

4.0%

Household Durables

7.2%

3.7%

–3.5%

Textiles, Apparel & Luxury Goods

6.4%

4.6%

–1.8%

Multiline Retail

6.1%

5.1%

–1.0%

Auto Components

4.7%

7.2%

2.5%

Internet & Catalogue Retail

2.9%

4.9%

2.0%

Leisure Equipment & Products

1.6%

0.1%

–1.5%

Diversified Consumer Services

1.6%

1.5%

–0.1%

Distributors

0.8%

0.6%

–0.2%

100.0%

100.0%

0.0%

Total

Difference

Note: Portfolio A might be a portfolio of all Consumer Discretionary stocks, or it can simply represent a neutral Consumer Discretionary sector allocation in a larger portfolio. The “difference” column shows the relative difference between the benchmark and Portfolio A. In this example, Portfolio A is most overweight to Media and most underweight to Automobiles. In other words, for this hypothetical example, Portfolio A’s owner expects Media to outperform the sector and Automobiles to underperform the sector. But in terms of benchmark risk, Portfolio A remains fairly close to the benchmark weights, so its relative risk is quite modest. This is extremely important: By managing against a benchmark, you can make strategic choices to beat the index and be well-diversified within the sector without concentrating too heavily in a specific area. Table 7.7 is another example of relative portfolio weighting versus the benchmark. Portfolio B is significantly underweight to Hotels, Restaurants & Leisure and most overweight to Media. Because the sub-industry weights are so different from the benchmark, Portfolio B takes on substantially more relative risk than Portfolio A.

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Table 7.7 Portfolio B Sub-Industry

MSCI World (%)

Portfolio A

Difference

Media

22.5%

38.3%

15.8%

Automobiles

19.5%

10.0%

–9.5%

Specialty Retail

14.7%

4.9%

–9.8%

Hotels, Restaurants & Leisure

11.9%

1.0%

–10.9%

Household Durables

7.2%

15.3%

8.1%

Textiles, Apparel & Luxury Goods

6.4%

0.2%

–6.2%

Multiline Retail

6.1%

4.2%

–1.9%

Auto Components

4.7%

12.9%

8.2%

Internet & Catalogue Retail

2.9%

4.2%

1.3%

Leisure Equipment & Products

1.6%

3.2%

1.6%

Diversified Consumer Services

1.6%

0.0%

–1.6%

Distributors

0.8%

5.7%

4.9%

100.0%

100.0%

0.0%

Total

Regardless of how your portfolio is positioned relative to the benchmark, it’s important to use benchmarks to identify where your relative risks are before investing. Knowing the benchmark weights and having opinions on the future performance of each industry is a crucial step in building a portfolio designed to beat the benchmark. Should you make the correct overweight and underweight decisions, you’re likelier to beat the benchmark regardless of the individual securities held within. But even if you’re wrong, you’ll have diversified enough not to lose your shirt.

Chapter Recap A more effective approach to sector analysis is “top-down.” A top-down investment methodology analyzes big-picture economic, political, and sentiment factors to forecast which investment categories are likely to outperform the market. A key part of the process is the use of benchmarks (such as the MSCI World Consumer Discretionary or S&P 500 Consumer Discretionary indexes), which are used

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as guidelines for building portfolios, monitoring performance, and managing risk. By analyzing portfolio drivers, we can identify which Consumer Discretionary industries and sub-industries are most attractive and unattractive, ultimately filtering down to stock selection. • The top-down investment methodology first identifies and analyzes highlevel portfolio drivers affecting broad categories of stocks. These drivers help determine portfolio country, sector, and style weights. The same methodology can be applied to a specific sector to determine industry and sub-industry weights. • Quantitative factor screening helps narrow the list of potential portfolio holdings based on characteristics such as valuations, liquidity, and solvency. • Stock selection is the last step in the top-down process. Stock selection attempts to find companies possessing strategic attributes consistent with higher-level portfolio drivers. • Stock selection also attempts to find companies with the greatest probability of outperforming their peers. • It’s helpful to use a Consumer Discretionary benchmark as a guide when constructing a portfolio to determine your industry overweights and underweights.

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8 SECURITY ANALYSIS

N

ow that we’ve covered the top-down method, let’s pick some stocks. This chapter walks you through analyzing individual Consumer Discretionary firms using the top-down method presented in Chapter 7. Specifically, we’ll demonstrate a five-step process for analyzing firms relative to peers. Every firm and every stock is different, and viewing them through the right lens is vital. Investors need a functional, consistent, and reusable framework for analyzing securities across the sector. While by no means comprehensive, the framework provided and the questions at this chapter’s end should serve as good starting points to help identify strategic attributes and company-specific risks. While volumes have been written about individual security analysis, a top-down investment approach de-emphasizes the importance of stock selection in a portfolio. As such, we’ll talk about the basics of stock analysis for the beginner-to-intermediate investor. For a more thorough understanding of financial statement analysis, valuations, modeling, and other tools of security analysis, additional reading is suggested.

151

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Top-Down Recap As covered in Chapter 7, you can use the top-down method to make your biggest, most important portfolio decisions first. However, the same process applies when picking stocks, and those high-level portfolio decisions ultimately filter down to individual securities. Step one is analyzing the broader global economy and identifying various macro “drivers” affecting entire sectors or industries. Using the drivers, you can make general allocation decisions for countries, sectors, industries, and sub-industries versus the given benchmark. Step two is applying quantitative screening criteria to narrow the choice set of stocks. It’s not until all those decisions are made that we get to analyze individual stocks. Security analysis is the third and final step. For the rest of the chapter, we assume you have already established a benchmark, solidified portfolio themes, made sub-industry overweight and underweight decisions, and are ready to analyze firms within a peer group. (A peer group is a group of stocks you’d generally expect to perform similarly because they operate in the same industry, possibly share the same geography, and have similar quantitative attributes.)

MAKE YOUR SELECTION Security analysis is nowhere near as complicated as it may seem—but that doesn’t mean it’s easy. Similar to your goal in choosing industry and sector weights, you’ve got one basic task: spot opportunities not currently discounted into prices. Or, put differently, know something others don’t. Investors should analyze firms by taking consensus expectations for a company’s estimated financial results and then assessing whether it will perform below, in line with, or above those baseline expectations. Profit opportunities arise when your expectations are different and more accurate than consensus expectations. Trading on widely known information or consensus expectations adds no value to the stock selection process. Doing so is really no different than trading on a coin flip. The top-down method offers two ways to spot such opportunities. First, accurately predict high-level, macro themes affecting an industry or group of companies—these are your portfolio drivers. Second, find firms that will benefit most if those high-level themes and drivers play out. This is done by finding firms with competitive advantages (we’ll explain this concept more in a bit).

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Since the majority of excess return is added in higher-level decisions in the top-down process, it’s not vital to pick the “best” stocks in the universe. Rather, you want to pick stocks with a good probability of outperforming their peers. Doing so can enhance returns without jeopardizing good top-down decisions by picking risky, go-big-or-gohome stocks. Being right more often than not should create outperformance relative to the benchmark over time. A FIVE-STEP PROCESS Analyzing a stock against its peer group can be summarized as a fivestep process: 1. 2. 3. 4. 5.

Understand business and earnings drivers. Identify strategic attributes. Analyze fundamental and stock price performance. Identify risks. Analyze valuations and consensus expectations.

These five steps provide a consistent framework for analyzing firms in their peer groups. While these steps are far from a full stock analysis, they provide the basics necessary to begin making better stock selections. Step 1: Understand Business and Earnings Drivers

The first step is to understand what the business does, how it generates its earnings, and what drives those earnings. Here are a few tips to help in the process. • Industry overview: Begin any analysis with a basic understanding of the firm’s industry, including its drivers and risks. You should be familiar with how current economic trends affect the industry. • Company description: Obtain a business description of the company, including an understanding of the products and services within each business segment. It’s always best to go directly to a company’s financial statements for this. (Almost every public

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•

•

•

•

•

firm makes their financial statements readily accessible online these days.) Browse the firm’s website and financial statements/reports to gain an overview of the company and how it presents itself. Corporate history: Read the firm’s history since its inception and over the last several years. An understanding of firm history may reveal its growth strategy or consistency with success and failure. It also will provide clues on what its true core competencies are. Ask questions like: Has it been an industry leader for decades, or is it a relative newcomer? Has it switched strategies or businesses often in the past? Business segments: Break down company revenues and earnings by business segment and geography to determine how and where it makes its money. Find out what drives results in each business and geographic segment. Begin thinking about how each of these business segments fits into your high-level themes. Recent news/press releases: Read all recently released news about the stock, including press releases. Do a Bing search and see what comes up. Look for any significant announcements regarding company operations. What is the media’s opinion of the firm? Is it a bellwether to the industry or a minor player? Markets and customers: Identify main customers and the markets it operates in. Determine whether the firm has any particularly large single customer or a concentrated customer base. Competition: Find the main competitors and how market share compares with other industry players. Is the industry highly segmented? Assess the industry’s competitive landscape. Keep in mind the biggest competitors can sometimes lurk in different industries—sometimes even in different sectors! Get a feel for how the firm stacks up—is it an industry leader or a minor player? Does market share matter in that industry?

Step 2: Indentify Strategic Attributes

After gaining a firm grasp of firm operations, the next step is identifying strategic attributes consistent with higher-level portfolio themes. Also

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known as competitive or comparative advantages, strategic attributes are unique features allowing firms to outperform their industry or sector. Since industry peers are generally affected by the same high-level drivers, strong strategic attributes are the edge in creating superior performance. Examples of strategic attributes include: • • • • • • • • • • • • • • •

High relative market share Low-cost production Superior sales relationships/distribution Economic sensitivity Vertical integration Strong management/business strategy Geographic diversity or advantage Consolidator Strong balance sheet Niche market exposure Pure play Potential takeover target Proprietary technologies Strong brand name First mover advantage

Strategic Attributes: Lemonade Stand How do strategic attributes help you analyze individual stocks? Consider a simple example: There are five lemonade stands of similar size, product, and quality within a city block. A scorching heat wave envelops the city, sending a rush of customers in search of lemonade. Which stand benefits most from the industry-wide surge in business? This likely depends on each stand’s strategic attributes. Maybe one is a cost leader and has cheapest access to homegrown lemons. Maybe one has a geographic advantage and is located next to a basketball court full of thirsty players. Or maybe one has a superior business strategy with a “buy two, get one free” initiative that drives higher sales volume and a bigger customer base. Any of these are core strategic advantages.

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Portfolio drivers help determine which kind of strategic attributes are likely to face head- or tailwinds. After all, not all strategic attributes will benefit a firm in all environments. For instance, Toyota’s rapidly expanding market share in SUVs and pickup trucks was a strategic attribute for much of the early part of the twenty-first century. But by the end of 2008, rising fuel costs, the trend toward energy efficiency, and a significant economic disruption resulted in financial difficulties for Toyota because of its exposure to SUVs and pickups. Thus, it’s essential to pick strategic attributes consistent with higherlevel portfolio themes. A strategic attribute is also only effective to the extent management recognizes and takes advantage of it. Execution is key. For example, if a firm’s strategic attribute is technological expertise, it should focus its effort on research and development to maintain that edge. If its strategic attribute is low-cost production relative to its peer group, it should capitalize by potentially lowering prices or expanding production (assuming the new production is also low cost) to gain market share. Identifying strategic attributes may require thorough research of the firm’s financial statements, website, news stories, history, and discussions with customers, suppliers, competitors, or management. Don’t skimp on this step—be diligent and thorough in finding strategic attributes. It may feel an arduous task at times, but it’s also among the most important in security selection. Step 3: Analyze Fundamental and Stock Price Performance

Once you’ve gained a thorough understanding of the business, earnings drivers, and strategic attributes, the next step is analyzing firm performance both fundamentally and in the stock market. Using the latest earnings releases and annual report, analyze company performance in recent quarters. Ask: • What are recent revenue trends? Earnings? Margins? Which business segments are seeing rising or falling sales?

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• Is the firm growing its business organically, because of acquisitions, or some other reason? • How sustainable is their strategy? • Are earnings growing because of strong demand or because of cost cutting? • Are they using tax loopholes and one-time items? • What is management’s strategy to grow the business for the future? • What is the financial health of the company? Not all earnings results are created equal. Understanding what drives results gives clues to what will drive future performance. Check the company’s stock chart for the last few years and try to determine what has driven performance. Explain any big up or down moves and identify any significant news events. If the stock price has trended steadily downward despite consistently beating earnings estimates, there may be a force driving the whole industry downward, like expectations for lower home prices. Likewise, if the company’s stock soared despite reporting tepid earnings growth or prospects, there may be some force driving the industry higher, like takeover speculation. Or stocks can simply move in sympathy with the broader market. Whatever it is, make sure you know. After reading the earnings calls of a firm and its peers (these are typically posted on the investor relations section of a firm’s website every quarter and transcripts can also be found at http://seekingalpha .com/tag/transcripts), you’ll begin to notice similar trends and events affecting the industry. Take note of these so you can distinguish between issues that are company specific or industry-wide. For example, economic growth or unemployment numbers often affect entire Consumer Discretionary industries, but currency fluctuation or a government’s tax policies may only affect specific producers. Step 4: Identify Risks

There are two main types of risks in security analysis: stock-specific risk and systematic risk (also known as non–stock specific risk). Both can be equally important to performance.

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Stock-specific risks, as the name suggests, are issues affecting the company in isolation. These are mainly risks affecting a firm’s business operations or future operations. Some company-specific risks are discussed in detail in the annual reports—10-K’s for US firms and the 20-F’s for foreign filers (found at www.sec.gov). But one can’t rely solely on firms’ self-identifying risk factors. You must see what analysts are saying about them and identify all risks for yourself. Some examples include: • • • • • • • • • • • • • • •

Stock ownership concentration (insider or institutional) Customer concentration Sole suppliers Excessive leverage or lack of access to financing Obsolete products Poor operational track record High cost of products versus competitors Late Securities and Exchange Commission (SEC) filings Qualified audit opinions Hedging activities Pension or benefit underfunding risk Regulatory or legal (pending litigation) Pending corporate actions Executive departures Regional, political/governmental risk

Systematic risks include macroeconomic or geopolitical events out of a company’s control. While the risks may affect a broad set of firms, they will have varying effects on each. Some examples include: • • • • •

Regional unemployment levels Industry cost inflation Economic activity Strained supply chain Legislation affecting taxes, royalties, or subsidies

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• Geopolitical risks • Interest rates • Currency Identifying stock-specific risks helps an investor evaluate the relative risk and reward potential of firms within a peer group. Identifying systematic risks helps you make informed decisions about which subindustries and countries to overweight or underweight. If you don’t feel strongly about any company in a peer group within a sub-industry you wish to overweight, you could pick the company with the least stock-specific risk. This would help to achieve the goal of picking firms with the greatest probability of outperforming their peer group and still perform in line with your higher-level themes and drivers. Step 5: Analyze Valuations and Consensus Expectations

Valuations can be tricky. They are tools used to evaluate market sentiment and expectations for firms. They are not a foolproof way to see if a stock is “cheap” or “expensive.” Valuations are primarily used to compare firms against their peer group (or peer average) or a company’s valuation relative to its own history. As mentioned earlier, stocks move not on the expected, but on the unexpected. We aim to try and gauge what the consensus expects for a company’s future performance and then assess whether that company will perform below, in line, or above expectations. Valuations provide little information by themselves in predicting future stock performance. Just because one company’s P/E is 20 while another’s is 10 doesn’t mean you should buy the one at 10 because it’s “cheaper.” There’s likely a reason why one company has a different valuation than another, including such things as strategic attributes, earnings expectations, sentiment, stock-specific risks, and management’s reputation. The main usefulness of valuations is explaining why a company’s valuation differs from its peers and determining if it’s justified.

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There are many different valuation metrics investors use in security analysis. Some of the most popular include: • • • • • • •

P/E—price-to-earnings P/FE—price-to-forward earnings P/B—price-to-book P/S—price-to-sales P/CF—price-to-cash-flow DY—dividend yield EV/EBITDA—enterprise value to earnings before interest, taxes, depreciation, and amortization

Once you’ve compiled the valuations for a peer group, try to estimate why there are relative differences and if they’re justified. Is a company’s relatively low valuation due to stock-specific risk or low confidence from investors? Is the company’s forward P/E relatively high because consensus is wildly optimistic about the stock? A firm’s higher valuation may be entirely justified, for example, if it has a growth rate greater than its peers. A lower valuation may be warranted for a company facing a challenging operating environment in which it is losing market share. Seeing valuations in this way will help to differentiate firms and spot potential opportunities or risks. Valuations should be used in combination with previous analysis of a company’s fundamentals, strategic attributes, and risks. For example, the following grid shows how an investor could combine an analysis of strategic attributions and valuations to help pick firms. Stocks with relatively low valuations but attractive strategic attributes may be underappreciated by the market. Stocks with relatively high valuations but no discernible strategic attributes may be overvalued by

Valuation Low Relatively Attractive Strategic Attributes Relatively Unattractive

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Valuation High

Best Worst

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the market. Either way, use valuations appropriately and in the context of a larger investment opinion about a stock, not as a panacea for true value. IMPORTANT QUESTIONS TO ASK While this chapter’s framework can be used to analyze any firm, there are additional factors specific to the Consumer Discretionary sector that must be considered. The following section provides some of the most important factors and questions to consider when researching firms in the sector. Answers to these questions should help distinguish between firms within a peer group and help identify strategic attributes and stock-specific risks. While there are countless other questions and factors that could and should be asked when researching Consumer Discretionary firms, these should serve as a good starting point. Product mix: Well-positioned firms maintain strong market share positions in a variety of products and in growing categories. How diversified is the firm’s revenue base? Is it highly exposed to a single product or end market? How does this compare to competitors? Does the firm produce hard-to-copy goods that are differentiated? Will its products benefit or suffer from trade-down or trade-up effects? Is the company’s product line especially exposed to a single input cost, like resin or copper? Geographic diversity: Firms with diversified end markets limit the likelihood of material country- or currency-specific profit disruptions. At the same time, these companies expand the potential market for their goods or services. What are growth expectations in the various regions in which the company operates? What is management’s experience in operating foreign subsidiaries? How successful has management been in previous foreign expansion? What systematic risks does the company expose itself to by opening a foreign subsidiary?

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Brand name: A well-respected brand gives a firm the ability to price its product above the competition, deflect substitution effects, and deliver superior profits to investors. Is the brand highly recognizable? Is it held in high or low regard? What are the firm’s strategies in promoting the brand? Have advertising campaigns surrounding key products coincided with increased revenue and market share? When will this brand do well and when will it fare poorly? Market share: Strong firms use dominant market share as a weapon against their competitors. High relative market share provides additional price flexibility compared to peers and favorable negotiating leverage with distributors and suppliers. How is management using its market share to maximize profits over competitors? Is its relative market share growing or shrinking? How did the company acquire this market share, and what would stop a competitor from stealing it away? Does market share matter in this industry? Client breakdown: Who are the firm’s clients? Are they wealthier than the average consumer? Less wealthy? How will changes in economic conditions impact the company’s target market? Are there demographic trends impacting a company’s target market? Is the company’s strategy congruent with the demands of its target market? Are the company’s clients located in a certain area? Is there a risk that a bankruptcy of a major client could materially impact a company’s profits or balance sheet? Does the company have exclusive contracts with its clients? Supplier breakdown: Where does the firm buy its supplies? This is important not just from a currency standpoint, but also geopolitically. Are any of its suppliers the only source for a certain material, component, or product? Is the supplier base well capitalized? When a company relies on a small group of suppliers, it will have less ability to negotiate on prices and more risk of a supply disruption. Is it cheaper to buy supplies from a third party or produce them internally?

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Balance sheet strength: Volatile profits can quickly endanger solvency for Consumer Discretionary firms, especially those relying on short-term financing. What is the company’s debt load relative to equity? When are its debts due? If the company is unable to secure new financing to retire maturing debt, does the company have cash or other assets it can use? Does the company use debt to leverage invested capital, or does it use debt to fund extraordinary events like unplanned working capital expansions? Is the company’s asset base anchored by real assets like property, plant, and equipment, high-quality accounts receivable, and inventory, or is it made up of intangible assets like goodwill? Barriers to entry: Barriers to entry can be industry or stock specific. Industry-level barriers refer to conditions inherent in an industry that limit competition. For instance, to be competitive in automobile manufacturing, a company needs to create significant manufacturing economies of scale. Similarly, consumer electronics companies require tremendous R&D budgets. Stock-specific barriers to entry refer to attributes a company has that it has created for itself. For instance, a difficult-to-copy business strategy or a design team with a strong track record of creating popular fashions represent barriers to entry at the company level. How is the company benefiting from barriers to entry? Are these barriers durable? Do valuations reflect the benefit the company gets from less competition? Earnings quality: What drives earnings for this company? Does the company have a track record of generating earnings from operations, or are earnings frequently boosted by asset sales or other one-time events? Earnings should be driven by the outcome of management’s performance versus its stated strategy. If a company’s annual report says its strategy is to maximize EBIT by growing sales through store expansion, but earnings growth over the last several years was driven by gains on short-term investments, for instance, a closer look may be

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warranted. On the other hand, if earnings were weak due to non-operating events like equity write-downs or asset disposals but operating results were better than expected, there could be an opportunity the Street is missing. Management: Managing a Consumer Discretionary company requires an individual who can not only respond to rapidly changing consumer tastes, but one who can anticipate and capitalize on them. In retail, for instance, a management team with a proven ability to predict next year’s fashion trends should be favored. What industry experience does management have to offer? How long has the team been managing this type of company? Has there been an unusually high level of turnover within the ranks? How is management performing relative to the strategy it’s outlined and the guidance it’s provided the market? Margins: Are margins growing or shrinking? Why? Has the company historically offset higher costs with higher prices? How do its margins compare to peers? Beware of firms who make uncharacteristic cuts to their advertising budgets—this is a common tactic to smooth short-term earnings that can have negative long-term implications. High margins in a vacuum tell you little as some industries historically hold higher margins than others, which is usually well known and taken into account in share prices. Expense items should be studied individually and carefully via the income statement. Line items such as selling, general, and administrative (SG&A) and R&D costs should be analyzed in relation to industry norms. Regulation: How are the firm’s operations affected by regulation? Does the firm currently operate in a favorable regulatory environment? How might that change? Monitor whether the firm you are looking at has incurred recalls of any sort as a result of governmental or safety group investigations.

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Legislation: Are there any legislative risks? These can include royalties, windfall taxes, environmental legislation, price caps, labor laws, subsidies, export taxes, tariffs, and the nationalization of assets. Regional trade agreements are particularly significant in distinguishing market access for a wide variety of consumer staples goods.

Chapter Recap Security analysis is not nearly as complicated as it seems. In the topdown investment process, stocks are essentially tools we use to take advantage of opportunities we identify in higher-level themes. Once an attractive segment of the market is identified, we attempt to find firms most likely to outperform their peers by identifying firms with strategic attributes. While the five-step security selection process is just one of many ways to research firms, it is an effective framework for selecting securities within the top-down process. Do not limit yourself to the questions provided in this chapter when researching Consumer Discretionary firms—they are just some tools to help you distinguish between firms. The more questions you ask, the better your analysis will be. • Stock selection, the third and final step in the top-down investment process, attempts to identify securities that will benefit from our high-level portfolio themes. • Ultimately, stock selection attempts to spot opportunities not currently discounted into prices. • To identify firms most likely to outperform their peer group, we must find firms that possess competitive advantages (aka strategic attributes). • A five-step security selection process can be used as a framework to research firms. • Firms within each industry have specific characteristics and strategies separating potential winners from losers. Asking the right questions can help identify those features.

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9 CONSUMER DISCRETIONARY INVESTMENT STRATEGIES

I

n this chapter, we’ll discuss various Consumer Discretionary investment strategies, including ideas about how to invest throughout a market cycle. The strategies include: • Adding value at the industry and sub-industry level • Adding value at the security level • Adding value in a Consumer Discretionary sector downturn While the strategies presented here are by no means comprehensive, they provide a good starting point for constructing a portfolio that can increase your likelihood of outperforming a Consumer Discretionary benchmark. They should also help spur some investment strategy ideas of your own. After all, using this framework to discover information few others have yet to discover is what investing is all about.

167

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STRATEGY 1: ADDING VALUE AT THE INDUSTRY AND SUB-INDUSTRY LEVEL The first strategy is overweighting and underweighting Consumer Discretionary industries or sub-industries based on your market outlook and analysis (e.g., the top-down method). Within the Consumer Discretionary sector, each industry and sub-industry falls in and out of favor frequently—no one area outperforms consistently over the long term. Even when the sector as a whole performs well, industries and sub-industries will have varying relative performance. A look at the performance of the MSCI All Country World Consumer Discretionary industries from 1995 to 2008 (Table 9.1) illustrates the variability of returns. We start tracking industry data in 1995 as this is the earliest that year-over-year comparisons are available. Calendar year industry total returns are compared to the Consumer Discretionary sector total returns. Shaded regions highlight when the industry outperformed the sector as a whole. The fundamentals, themes, and drivers covered in this book can be seen throughout the time period. Notably: • Autos & Components outperformed from 2000 to 2007 with the exception of 2004, when it performed in line with the sector. Over this period, global auto sales grew significantly, boosting profits and returns. • Consumer Services outperformed from 2002 to 2008 due to strong performance from McDonald’s, which represents over 30 percent of the index. During that period, McDonald’s implemented a major restructuring and expansion plan, significantly improving sales and profitability. • Media underperformed from 2001 to 2005 at first due to economic weakness, and then from the impact of weakening physical sales of content like music and movies. Time Warner, Vivendi, and Disney had the largest negative impact from this trend. • Retailing outperformed for much of the period as strong economic growth from 1997 to 1999 and 2003 to 2005 boosted

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6.9 –48.8 2.3 41.4 22.3

–42.1 2.2 39.2 23.1

2008

Annualized Return

Cumulative Return

Standard Deviation

Source: Thomson Reuters.

28.9

20.9 –1.9

10.2

2.6

2005

2007

12.2

15.6

2004

2006

41.9

38.5

2001

2003

–7.4

–9.6

2000 –7.3

–23.0

–24.0

1999

–21.7

13.7

35.1

1998

2002

5.3 11.7

8.4

23.0

12.9

1996 24.2

5.2

11.6

1995

1997

Automobiles & Components (%)

Consumer Discretionary Sector (%)

26.4

–2.7

–0.2

–47.1

–0.3

14.1

8.9

16.5

32.0

–13.1

–18.4

–24.1

63.8

7.5

–10.5

3.1

10.3

Consumer Durables & Apparel (%)

21.9

99.3

4.7

–34.0

3.3

24.9

3.0

32.9

49.5

–16.5

–10.2

–14.8

6.0

17.7

3.5

14.8

20.9

Consumer Services (%)

25.4

22.4

1.4

–39.6

–6.2

26.5

–6.9

6.7

31.2

–32.4

–18.2

–19.6

43.5

24.6

20.1

13.4

21.1

Media (%)

Table 9.1 MSCI All Country World Consumer Discretionary Industry Total Returns

26.1

99.2

4.7

–37.7

–9.1

12.1

3.7

22.0

43.0

–22.9

6.9

–29.0

38.6

48.5

19.3

10.4

9.4

Retailing (%)

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returns. Also, industry giant Home Depot benefited through much of that period from strong demand for home improvement products tied to the booming housing market. • Consumer Durables & Apparel displayed minimal consistency and the highest volatility. This is due to the industry group’s high operating leverage and low average market cap. Ultimately, your decision to overweight or underweight a subindustry relative to the benchmark should jibe with your high-level portfolio drivers. Based on the themes and drivers covered throughout this book, you should now have a good understanding of the basic fundamentals driving stock market returns and the tools to track them moving forward. Note: Always remember past performance is no guarantee of future performance. No set of rules works for all time, and you should always analyze the entire situation before investing—starting with expectations of how supply and demand may shift. The past is about understanding context and precedent for investing—it’s not a road map for the future. Implementing Sub-Asset Allocation Overand Underweights

Once you’ve evaluated a sector’s fundamentals and formed opinions about expected returns, follow these two steps to implement industry or sub-industry allocation over- and underweights: 1. Determine the weight relative to your benchmark’s weight in that category. The size of your relative bet should be proportional to your conviction. When you have only mild conviction, make a modest bet against the benchmark. When you believe you have significant information others don’t have, make a bigger bet. But never make a bet so large that, if you’re wrong, will inflict irreparable damage to your portfolio’s return versus the benchmark. 2. Determine how you plan to fill out the allocation. You have several alternatives: You might simply buy all the stocks in that

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category if you don’t feel you have any useful security-specific insights. You might buy some representative stocks, perhaps either the biggest or those with the highest correlation to the category. You might buy an exchange-traded fund (ETF) or mutual fund that encompasses the category. (For more information on available ETFs, visit www.ishares.com, www.sectorspdr .com, or www.masterdata.com.) Or you might try to add additional value with security selection strategies.

Industry Cheat Sheet Sectors and their components are dynamic, and fundamentals change over time. For reference, here’s a quick cheat sheet with pointers on each Consumer Discretionary industry. MEDIA

• Media companies are a good play on economic growth since profits are generated via advertising and home entertainment sales, both of which benefit from a growing economy. • Movies & Entertainment is the largest sub-industry and closely tied to broad economic trends, while Cable & Satellite broadcasters are more defensive due to the subscription-based revenue model. • Broadcasters (television or radio) are linked to local advertising spending. Local ads are primarily purchased by auto manufacturers and financial companies, exposing broadcasters to trends in autos and finance. AUTOMOBILES

• Automobiles are a major financial commitment for most customers and are thus linked to sentiment, economic growth, and interest rates. Interest rates impact the ability to use credit to purchase a car. • Raw materials and currency should also be considered when evaluating automobile manufacturers because both have the potential to materially impact earnings. • Similarly, it is important to understand labor relations and government involvement since both can materially impact profitability separate from demand. (Continued)

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SPECIALTY RETAIL

• Aside from overt dependence on consumer spending, it is important to evaluate the end market a specialty retailer serves. Home Depot, for example, is linked more closely to housing turnover than broader consumer spending. HOTELS, RESTAURANTS & LEISURE

• Demand is strongest for hotels when business activity is robust and travel costs are low. Global economic development, especially in emerging markets, is good for hotels as new construction expands sales and profits. • Restaurants benefit from consumer spending and low costs for beef, chicken, wheat, and dairy. • Leisure represents a small portion of the sector, and, despite relatively stable revenues from certain realities of gambling, these companies are often volatile due to often significant financial leverage associated with building new resorts and casinos. HOUSEHOLD DURABLES

• Consumer Electronics, the largest portion of the industry, is driven by consumer spending trends, innovation, and emerging markets growth. These firms are found primarily in Japan and Southeast Asia and are characterized by heavy R&D spending, operationally leveraged, component supply and demand, and currency fluctuation. • The rest of the industry is composed of homebuilders and other appliance and home furnishing manufacturers, which are linked closely to housing demand. These are typically small, high operating leverage businesses and performance is often volatile. TEXTILES, APPAREL & LUXURY GOODS

• Textile and Apparel manufacturers are linked to demand from retailers for inventory. As such, shares are driven by operational performance of retailers, regional labor costs, and general economic conditions. • Demand for luxury goods is typically more resilient than that of mass-market brands due to the wealthier target demographic. Global economic growth benefits these companies because the base of affluent consumers grow.

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MULTILINE RETAIL

• Department stores often outperform early in the economic cycle and rely on gains in consumer spending and demand for home furnishings and appliances. A growing economy drives both conditions. • General merchandisers are increasingly synonymous with discounters. These companies benefit when consumers trade down to cheaper products, providing in an economic downturn. AUTO COMPONENTS

• Auto Component manufacturers are essentially high-beta plays on Auto manufacturers. They are typically small, have high operating leverage, and rely on debt financing to fund production. • Since demand for replacement and spare parts is caused by the age and size of the used car fleet, manufacturers with a large relative exposure to the aftermarket may benefit when new car demand declines. Additionally, margins are higher in the aftermarket. LEISURE EQUIPMENT & PRODUCTS

• This segment is highly discretionary (elastic) and therefore generally more volatile relative to the rest of the sector. Demand for sporting goods is driven by major events like the World Cup and the Olympics; however, purchases are easily deferred. • The segment makes up a very small portion of the overall sector. DIVERSIFIED CONSUMER SERVICES

• Companies in this segment have little or no direct exposure to economic growth and are driven more by company-specific demand drivers than anything else. • The notable exception is Education Services, which often benefit when employment is falling. As jobs become scarce, consumers will often go back to school for additional certifications. DISTRIBUTORS

• This is the smallest segment of the sector and is dominated by one or two companies. Distributors benefit when economic growth is weak and companies have difficulty financing inventories and supply chains.

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STRATEGY 2: ADDING VALUE AT THE SECURITY LEVEL A more advanced strategy entails investing in firms within a subindustry based on a specific earnings drivers. This strategy could be based on different opinions about economic growth, consumer spending, interest rates, commodities costs, or some combination of all the above. For example, if you think economic growth will be strong, but housing demand will be weak due to high interest rates, you could: • Buy media companies and short homebuilders • Buy apparel retailers and short home improvement retailers • Buy media firms and short consumer durables manufacturers who rely heavily on debt financing • Buy debt-free durable goods manufacturers and sell debtfinanced durable goods manufacturers • Buy retailers with high-quality credit card portfolios, short tool makers with leverage to homebuilding These are just a few examples. Countless other tactics could be employed within sub-industries. A word of caution: Using shorts and similar tactics generally requires a bit more investing acumen than the novice. As you become familiar with specific Consumer Discretionary firms and their industries, you can eventually develop your own strategies. Always be vigilant for company-specific issues that could cause a stock to act differently than you would expect in the context of your broader strategy. (And be sure to revisit Chapter 8 for how to select individual stocks.) STRATEGY 3: ADDING VALUE IN A CONSUMER DISCRETIONARY SECTOR DOWNTURN Most of this book focused on what drives the Consumer Discretionary sector and its industries forward. But what could cause a Consumer Discretionary sell-off? No one sector or industry can outperform forever. The stock market eventually sniffs out all opportunities for excess returns and sector leadership changes. So it’s important to

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continually review all the drivers and question your high-level portfolio themes regularly. One obvious trigger for a Consumer Discretionary sector downturn would be a decline in consumer spending. Remember, by the time consumer spending begins to decline, Consumer Discretionary stocks will have likely already begun discounting the expectation of lower spending—stocks are the ultimate leading indicator. There are many signs a slowdown in spending could be on the way: • Growth in Non-Farm Payrolls begins to slow, while the unemployment rate increases. • Wage growth begins to lag inflation. • Growth in disposable income begins to slow due to weakening employment, falling real wages, higher taxes, or some combination of these. • Interest rates rise and credit availability dries up, reducing consumers’ ability to purchase big-ticket items. • Sentiment surveys report consumers are increasingly unlikely to spend (keeping in mind sentiment surveys are backward looking). Similarly, investor preference for cyclical stocks could weaken. This can be caused by any number of factors, including: • Expectations for slowing global economic growth • Expectations for a bear market • Valuations for cyclical assets reach unattractive levels relative to other investments • Rising global inflation • Restrictive monetary policy by central banks Should your analysis lead you to believe the next 12 months will be a bad time for Consumer Discretionary stocks—because of the reasons above or something else—then it may be appropriate to either reduce or eliminate your weight in Consumer Discretionary firms or adopt a defensive position in the portfolio.

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HOW TO IMPLEMENT YOUR STRATEGY As with the overweight decision, how much you underweight relative to your benchmark should be driven by the strength of your conviction. If you have lower or negative expectations for the sector, you can: • Reduce your exposure to the Consumer Discretionary sector by selling your Consumer Discretionary stocks. • Buy less economically sensitive Consumer Discretionary subindustries, like Cable & Satellite broadcasters, or certain countercyclical sub-industries, like Education Services. • Purchase ProShares UltraShort Consumer Goods (ticker: SZK) and/or ProShares UltraShort Consumer Services (ticker: SCC) ETFs, or a similar product. But be careful—these are leveraged ETFs that provide double the inverse return of the underlying securities. If you have strong convictions and are right, these can serve you well. But if your forecast is wrong, too great an allocation to a leveraged ETF can impact your overall relative return. • Buy puts or sell calls (i.e., options) on Consumer Discretionary stocks. • Buy puts or sell calls on Consumer Discretionary Index ETFs (ticker: XLY or VCR).

Selling Short If, after reviewing Consumer Discretionary drivers, you determine the outlook for the sector is negative, one way to limit losses is to sell all your Consumer Discretionary stocks. However, there are investment strategies that benefit when stock prices are falling. Selling short allows you to borrow shares in a company you do not own and sell them immediately. The shares you borrowed are due back to the lender (typically a brokerage) at their discretion. If the share price declines, you can buy the shares back at a lower level and return them to the lender (also called “covering”), pocketing the difference (net transaction costs).

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But be careful! While your potential upside is limited (the stock price can only go to zero, it will never be negative), your potential downside is infinite because shares could continue to appreciate in perpetuity—you might have to cover the short sale by buying the stock at a much, much higher price. Also, if the stock you shorted continues rising, the share lender may force you to immediately cover your position resulting in a loss.

Because of the potential leverage involved, strategies involving options (which can be used either to augment an over- or underweight) and margin should only be used by sophisticated investors. Shorting is also a more sophisticated strategy. Keep in mind, significantly deviating from your benchmark involves the significant risk of missing equity-like upside should you be wrong. Significant deviations from your benchmark should only take place when you have strong convictions that you know something others do not. Chapter Recap We couldn’t possibly list every investment strategy out there for this dynamic sector. Different strategies will work best at different times. Some will become obsolete. New ones will be discovered. Whatever strategies you choose, always know you could be wrong! Decisions to significantly overweight or underweight a sub-industry relative to the benchmark or using shorting or options strategies should be based on a multitude of factors, including an assessment of risk. The point of benchmarking is to properly diversify, so make sure you always have counterstrategies built into your portfolio. • There are numerous ways to invest in the Consumer Discretionary sector. These include investing in indexes or mutual funds or buying the stocks themselves. • Investors can enhance returns by overweighting and underweighting Consumer Discretionary industries based on a variety of high-level drivers. For example, Cable & Satellite tends to underperform other Media sub-industries in periods of strong economic growth. • When your investment outlook is negative, there are several ways to limit investment losses or even benefit, including reducing your exposure to the sector, investing in inverse ETFs, or buying puts against Consumer Discretionary securities.

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Notes

CHAPTER 1: CONSUMER DISCRETIONARY BASICS 1. Bureau of Economic Analysis.

CHAPTER 2: THE HISTORY OF THE CONSUMER DISCRETIONARY SECTOR 1. Lawrence B. Glickman, Consumer Society in American History: A Reader (Cornell University Press, 1999). 2. “A Brief History of Jamestown, Virginia,” Tobacco.org, http://www .tobacco.org/History/Jamestown.html (accessed December 10, 2009). 3. Frank E. Grizzard and D. Boyd Smith, Jamestown Colony: A Political, Social, and Cultural History (ABC-CLIO, 2007). 4. James Axtell, “The First Consumer Revolution,” in Consumer Society in American History: A Reader (Cornell University Press, 1999), 85. 5. “The Stamp Act,” USHistory.org, http://www.ushistory.org/declaration/ related/stampact.htm (accessed December 10, 2009). 6. Sean Cashman, America in the Gilded Age, 3rd ed. (New York: NYU Press, 1993), 1. 7. Ibid. 8. Global Financial Data, Inc. 9. The Kingfisher History Encyclopedia, Part 20 (Oxford University Press, 2004), 382. 10. “History of Sears Modern Homes,” Sears, http://www.searsarchives .com/homes/history .htm (accessed December 10, 2009). 11. “NAHB History Timeline,” National Association of Home Builders, http://www.nahb.org/NAHB_History/historytimeline.html (accessed December 10, 2009). 12. Internal Revenue Service. 13. Lawrence Herzog, “Remembering the Drive-In Restaurant,” Edmonton Real Estate Weekly, February 14, 2008, I6. 179

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180

Notes

CHAPTER 3: CONSUMER DISCRETIONARY SECTOR DRIVERS 1. 2. 3. 4. 5. 6. 7. 8.

Bureau of Economic Analysis, as of 06/30/2009. Ibid. Whirlpool 10-K, as of 12/31/2008. See note 1. American Gaming Association. Ibid. Banco Central do Brasil as of 6/30/2009. Thomson Reuters, Brazilian Institute for Geography and Statistics from 2002 through 2008.

CHAPTER 4: CONSUMER DISCRETIONARY SECTOR LANDSCAPE 1. MSCI. The MSCI information may only be used for your internal use, may not be reproduced or redisseminated in any form and may not be used to create any financial instruments or products or any indices. The MSCI information is provided on an “as is” basis and the user of this information assumes the entire risk of any use made of this information. MSCI, each of its affiliates and each other person involved in or related to compiling, computing or creating any MSCI information (collectively, the “MSCI Parties”) expressly disclaims all warranties (including, without limitation, any warranties of originality, accuracy, completeness, timeliness, non-infringement, merchantability and fitness for a particular purpose) with respect to this information. Without limiting any of the foregoing, in no event shall any MSCI Party have any liability for any direct, indirect, special, incidental, punitive, consequential (including, without limitation, lost profits) or any other damages. 2. See note 1. 3. See note 1. 4. See note 1. 5. Bureau of Economic Analysis. 6. Lee Hawkins Jr. and Norihiko Shirouzu, “A Tale of Two Auto Plants,” The Wall Street Journal (May 24, 2006), http://online.wsj.com/article/ SB114842282919261094.html (accessed December 10, 2009). 7. Rhys Blakely, “Nano Costs Could Leave Tata Out of Pocket,” Times Online (August 5, 2008), http://business.timesonline.co.uk/tol/business/ industry_sectors/engineering/article 4460258.ece (accessed December 10, 2009).

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8. International Organization of Motor Vehicle Manufacturers. 9. Sony, Panasonic, and Sharp Annual Reports from 2000 to 2009. 10. Fred Fishkin and Jonathon Thaw, “Sony Says Prices for LCD Televisions Will Fall Less this Year,” http://www.bloomberg.com/apps/news?pid=co newsstory&refer=conews&tkr=SNE:US&sid=a6ShvAizwVZg.

CHAPTER 5: CHALLENGES IN THE CONSUMER DISCRETIONARY SECTOR 1. 2. 3. 4. 5.

6.

7. 8. 9. 10. 11. 12. 13. 14. 15. 16. 17. 18.

Bloomberg Finance, L.P. Ibid. DigiTimes. Ibid. “Industry Note: New Appliance Share Data Highlights Regulatory Challenges for WHR/MYG,” Citigroup Global Markets Research (September 6, 2006). Michael Copeland, “Stuck in the Spin Cycle,” CNN Money (May 1, 2005), http://money.cnn.com/magazines/business2/business2_archive/2 005/05/01/8259675/index.htm (accessed December 10, 2009). See note 5. See note 1. See note 1, as of 9/15/2009. Peers include Russell 2000 Value Apparel Retailers. Ibid. See note 1. See note 1. See note 1. See note 1. See note 1. See note 1. See note 1. See note 1.

CHAPTER 6: HOUSEHOLD DEBT—MYTHS AND OPPORTUNITIES 1. Alan Greenspan and James Kennedy, “Finance and Economics Discussion Series: Sources and Uses of Equity Extracted from Homes” (March 2007), http://www.federalreserve.gov/PUBS/feds/2007/200720/ 200720pap.pdf (accessed December 10, 2009). 2. Ibid.

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182

Notes

3. Kimberley Beaton, “Credit Constraints and Consumer Spending” (September 28, 2009), http://www.policypointers.org/Page/View/10052 (accessed December 10, 2009). 4. Thomson Reuters. 5. Ibid. 6. Ibid.

CHAPTER 7: THE TOP-DOWN METHOD 1. Matthew Kalman, “Einstein Letters Reveal a Turmoil Beyond Science,” Boston Globe (July 11, 2006), http://www.boston.com/news/world/ middleeast/articles/2006/07/11/einstein_letters_reveal_a_turmoil_ beyond_science/ (accessed December 10, 2009). 2. Michael Michalko, “Combinatory Play,” Creative Thinking, http:// www.creativethinking.net/DT10_CombinatoryPlay.htm?Entry=Good (accessed December 10, 2009). 3. Gary P. Brinson, Brian D. Singer, and Gilbert L. Beebower, “Determinants of Portfolio Performance II: An Update,” The Financial Analysts Journal 47 (1991), 3. 4. Source: MSCI. The MSCI information may only be used for your internal use, may not be reproduced or redisseminated in any form and may not be used to create any financial instruments or products or any indices. The MSCI information is provided on an “as is” basis and the user of this information assumes the entire risk of any use made of this information. MSCI, each of its affiliates and each other person involved in or related to compiling, computing or creating any MSCI information (collectively, the “MSCI Parties”) expressly disclaims all warranties (including, without limitation, any warranties of originality, accuracy, completeness, timeliness, non-infringement, merchantability and fitness for a particular purpose) with respect to this information. Without limiting any of the foregoing, in no event shall any MSCI Party have any liability for any direct, indirect, special, incidental, punitive, consequential (including, without limitation, lost profits) or any other damages. 5. Ibid. 6. See note 4. 7. See note 4.

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About the Authors

Erik Renaud (San Francisco, California) is a Consumer Discretionary Research Analyst at Fisher Investments. Erik graduated from Santa Clara University with a bachelor’s degree in Finance and is originally from Minnetonka, Minnesota. Andrew S. Teufel (San Francisco, California) has been with Fisher Investments since 1995 where he currently serves as a Co-President and Director of Research. Prior to joining Fisher, he worked at Bear Stearns as a Corporate Finance Analyst in its Global Technology Group. Andrew also instructs at many seminar and educational workshops throughout the US and UK and has lectured at the Haas School of Business at UC Berkeley. He is also the Editor-in-Chief of MarketMinder.com. Andrew is a graduate of UC Berkeley.

183

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Index

Accounting guidelines, 102 Acquisitions, 95–96 Advertising, 81. See also Media industry Alcohol sales, 8 Amazon.com, 100 Apparel. See Consumer Durables and Apparel industry Appliance manufacturers, 29–30, 95–96. See also Consumer Durables and Apparel industry Assembly line manufacturing process, 27 Auto components industry, 70–72, 89, 168, 172 Automobile industry, 66–72, 89 barriers to entry in, 68 characteristics of, 66–67 components, 70–72, 168, 172 demand cyclicality, 67–68 government regulation of, 68 history of, 26–28 overview, 13–14 performance, 168

pointers about, 171–172 and regulation, 52–53 Top 10 manufacturers, 69 and trade policies, 51–52 Balance sheet strength, 163 Barriers to entry, 68, 79, 82–84, 163 Beeronomics, 8 Bellwethers, 65–66 Benchmarks: defined, 61, 135 differences in, 61–63 managing against, 145–148 MSCI ACWI Sector Weights, 4, 63, 146–148, 169 in top-down investing, 135–138 Black Friday, 13 Blanc, Honore, 29 Books. See Publishing industry Bottom-up investing, 132–133 Boucicaut, Aristide, 26 Boycotts, 22 Brand loyalty, 93 Brand name, 162

185

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186

Index

Brazil, economy of, 53–54, 118–125 Broadcasting, 80–81. See also Media industry Business and earnings drivers, 153–154 Cable & Satellite industry, 78–80. See also Media industry Callaway Golf, 93, 106–109 Cardoso, Fernando, 53, 120–122 Case studies: Brazil’s credit-driven consumption boom, 118–125 Callaway Golf, 106–109 Cash out refinancing, 116 Casinos, 88 Causation, 6 Central Bank interest rates, 47–48 Ceteris paribus, 98 Chrysler, 53, 69–70 Client breakdown, 162 Combinatory play, 132 Company management, 164 Comparable store sales (comps), 74–75 Consensus expectations analysis, 159–161 Consumer Discretionary sector: breakdown of industry groups and industries, 60–61 characteristics of, ix–x, 5–7

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correlation with S&P 500, 10 history of, 19–33 industry cheat sheet, 171–173 industry examples, 3–4 overview, 17, 89 services spending and industry group performance, 43 stock price performance and economic growth, 9 Consumer Durables and Apparel industry, 15–16, 81–86, 89 appliances, 29–31 consumer electronics, 82–84 household durables, 82–84 interchangeable parts, 28–29 luxury goods manufacturers, 86 performance, 170 textile and apparel manufacturers, 28, 85–86 Consumer electronics firms, 82–84. See also Consumer Durables and Apparel industry Consumer goods, defined, 5 Consumer lending. See Household debt Consumer sentiment: and automobile industry, 14 and Consumer Durables, 16 as market driver, 54–56 and Media industry, 15 and Retail industry, 15 role in forecasting, 10–13

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Index

Consumer Services industry, 16, 86–88, 89 casinos & gaming and leisure facilities, 88 diversified consumer services, 88 history of, 31–32 hotels, resorts, and cruise lines, 87–88 performance, 168 pointers about, 172 restaurants, 87 Consumer spending: breakdown of, 38 and disposable income, 43–45 durable goods, 38, 40–41 growth, in Brazil, 125 non-durable goods, 38, 41–42 as a percent of GDP, 40 and recessions, 40 services, 38, 42–43 Consumer Staples sector, ix–x Contrarians, 142 Correlation coefficient, 7 Correlations, 6–7 Credit: case study, Brazil, 118–125 cash out refinancing, 116 credit crisis of 2008, 112–114 home equity and disposable income, 114–115 Mortgage Equity Withdrawals (MEWs), 114–116 purpose of, 111 wealth effect, 114 Credit agreements, 105–106

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187

Cruise Lines, 88 Currency: as economic driver, 48–49 stabilization of, 118–122 Cyber Monday, 13 Debt, household, 112–113, 117–118 Debt covenants, 106 Debt financing, 105–106 Defensive sectors, 5 Demand, elastic vs. inelastic, 5 Demand drivers, 7 Demand volatility, 101–109 Department stores, 73 Dickson, William, 25 Disposable income: and consumer spending, 43–45 and home equity, 114–115 and wage growth, 44 Distribution, 100 Distributors, 74, 172 Diversified consumer services, 88, 172 Dress Barn, 99 Drivers, 35–56 analysis of, in top-down investing, 139–142 business and earnings, 153–154 creating, 142 economic, 36–49, 140 political, 49–54 sentiment, 54–56 table of types, 140 Durable goods, 38, 40–41

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188

Index

Earnings quality, 163–164 Eastman, George, 24 Economically sensitive cyclical demand, 67–68 Economic drivers, 36–49, 140 consumer spending, 38–43 currency, 47–48 economic growth, 47 income and employment, 43–47 interest rates, 47–48 Economic growth: and Consumer Discretionary stock price performance, 9 as economic driver, 47 Economic liberalization, 53–54 Edison, Thomas, 25 Einstein, Albert, 130–132 Elastic vs. inelastic demand, 5 Employment: as economic driver, 45–47 Gross Domestic Product (GDP) and, 46 Evans, Oliver, 23 Exchange Traded Funds (ETFs), 145 Expansion management, 100–101 Fast food, 32 Federal Reserve, 47–48 Film industry. See Media industry Firm performance analysis, 156–157 Ford Motor Company, 27 Free cash flow (FCF), 79

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French and Indian War, 21, 22 Fur trade, 21 General merchandisers, 73–74 General Motors, 53, 69 Geographic diversity, 161 Global Consumer Discretionary Benchmarks, 61–66 Global Industry Classification Standard (GICS), 60 Goodwin, Hanibal, 24 Gross Domestic Product (GDP), 40 Haier, 95–96 Harvey, Fred, 32 Homebuilding industry, 29–31, 84. See also Consumer Durables and Apparel industry Home equity: cash out refinancing, 116 and disposable income, 114–115 Hotel industry, 87, 172. See also Consumer Services industry; Lodging Household debt, 112–113, 117–118 Household Durables, 82–84, 172 Income, disposable, 43–45 Industrial Revolution, 22–23 Industry concentration, 65–66 Industry weights, 64, 65

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Index

Inflation, and Brazilian economy, 118–125 Inflation targeting, 122 Initial markup (IMU) maximization, 99 Interchangable parts, 28–29 Interest rates, as economic driver, 47–48 Internet and catalogue retailers, 74. See also Retail industry Investing. See Investment strategies bottom-up method, 132–133 rules and styles, 130 top-down method, 132–145 Investment strategies, 167–177 adding value at industry and sub-industry level, 168–173 adding value in a downturn, 174–175 implementation, 176–177 Jamestown, 20 Japan, and consumer electronics, 82–84 Jewelry industry, 93 Kroc, Ray, 32 Legislation, 165 Leisure equipment and products, 172 Leisure industry. See Consumer Services industry

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189

Leverage ratio, 106, 107–108 Lodging, 31–32. See also Consumer Services industry; Hotel industry Lula (Luiz Enacio Lula Da Silva), 53 Luxury goods manufacturers, 86 Macy’s, 102 Magazines. See Publishing industry Margins, 164 Marketing and promotions, 92–93 Market share, 92–97, 162 Maytag, 95–96, 98 McDonald’s, 32 Mechanization of industries, 22–23 Media industry, 15, 76–81, 89 advertising, 81 broadcasting, 80–81 cable & satellite, 78–80 history of, 24 major companies in, 78 movies & entertainment, 24–25, 77–78 performance, 168 pointers about, 171 publishing, 80 Mergers and acquisitions, 95–96 Monopolies, 79 Montgomery Ward, 25–26 Mortgage Equity Withdrawals (MEWs), 114–116

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Index

Movies and entertainment, 24–25, 77–78. See also Media industry MSCI ACWI Sector Weights, 4, 63, 146–148, 169 Multiline retailers, 14, 73–74, 172 Music industry. See Media industry

Profit growth, 91–97 Profit margins, 103–104 Publishing industry, 80. See also Media industry

Native Americans, 20–21 Newspapers, 24. See also Media industry; Publishing industry Newton, Sir Isaac, 131 Non-durable goods, 38, 41–42 Nordstrom, 102

Receivables Investment Fund, 122 Recessions, and consumer spending, 39 Regulation, 52–53, 164–165 Replacement cycle, 67–68 Restaurants, 86, 172. See also Consumer Services industry Retail industry, 14–15, 72–76 characteristics of, 74–76, 79 distributors, 74 history of, 25–26 Internet and catalogue retailers, 74 multiline retailers, 14, 73–74, 172 performance, 168 pointers about, 172 specialty retailers, 14, 72–73 Risk identification, 157–159 Risk management, 134 Rolfe, John, 20 R-Squared, 7

Only Three Questions that Count, The (Fisher), 142 Operating leverage, 103–104 Operational efficiency improvement, 97–101 Original equipment manufacturers (OEMs), 70–71 Personal consumption expenditures (PCE), 7 Political drivers, 49–54, 140, 141 economic liberalization, 53–54 regulation, 52–53 taxes, 49–51 trade policy, 51–52 Polo Ralph Lauren, 99 Product innovation, 94–95 Production, location of, 98, 99–100 Product mix, 161 Product planning, 99

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Quantitative factor screening, 143–144

S&P 500 Consumer Discretionary, 9, 10 Scalability, 133 Sears, 30

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Index

Sector weights, 4, 61–63 Securitization, in Brazil, 122–124 Security analysis, 151–165 5 steps in, 153–161 questions to ask, 161–165 Selling short, 176–177 Senior Loan Officer Study (SLOS), 117 Sentiment drivers, 54–56, 140, 141–142 Services, as economic driver, 38, 42–43 Shorting, 176–177 Smith, John, 20 Sourcing, 99 Specialized Consumer Services. See Consumer Services industry Specialty retailers, 14, 72–73 Sporting goods industry, 93, 106–109 Standardized assembly, 29 Starbucks, 100–101 Stock selection, 144–145. See also Security analysis Stock-specific risk, 158 Strategic attributes, 154–156 Supplier breakdown, 162 Supply chain management, 99–100 Systematic risk, 158–159 Target, 74, 100 Taxes, as political driver, 49–51 Television. See Media industry

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191

Textile and Apparel manufacturers, 28, 85–86, 172 Tiffany & Co., 93 Tobacco, 20 Top-down investing, xi, 132–145 advantages of, 133–134 allocation importance, 134–135 benchmarks in, 135–138 defined, 133 driver analysis, 139–142 quantitative factor screening, 143–144 steps illustration, 139 stock selection, 144–145 summary of, 152 (see also Security analysis) Tourism, 31. See also Consumer Services industry Toyota, 99–100, 156 Trade policy, as political driver, 51–52 Travel industry. See Consumer Services industry TV technology innovation, 94–95 Two-fleet rule, 52–53 Valuations analysis, 159–161 VF Corp., 85 Wage growth, 44, 45 Wealth effect, 114 Weighting, 168–173 Whirlpool, 48–49, 95–96, 98 Whitney, Eli, 23, 28, 29

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(continued from front flap)

$49.95 USA / $59.95 CAN

Filled with in-depth insights and expert advice, Fisher Investments on Consumer Discretionary provides

T

a framework for understanding this sector and its industries to help you make better investment decisions—now and in the future. With this book as

on CONSUMER DISCRETIONARY

understand and analyze investment opportunities—

Consumer Discretionary sector and discover strategies

This installment of the Fisher Investments On series is a comprehensive guide to the Consumer

to help achieve your investing goals.

Discretionary industry—which includes companies such as auto manufacturers, homebuilders,

on

CONSUMER DISCRETIONARY

sports equipment manufacturers, hotel developers and operators, cruise lines, retail websites, and department stores, to name just a few.

Analyst at Fisher Investments. Renaud graduated from Santa Clara University with a bachelor’s degree in finance. Hailing from Minnetonka, Minnesota, he currently resides in San Francisco, California.

ANDREW S. TEUFEL has been with Fisher Investments since 1995, where he currently serves as

Stearns as a corporate finance analyst in its Global Technology Group. Teufel also instructs at many seminars and educational workshops throughout the United States and United Kingdom, and has lectured

Consumer Discretionary sector. It shows how to determine better times to invest in Consumer Discretionary, which Consumer Discretionary industries and sub-industries are likelier to do best, and how individual stocks can benefit in various environments. The global Consumer Discretionary sector is complex, covering many sub-industries and countries with unique

or other components of the global stock market. While this guide specifically focuses on Consumer Discretionary, the basic investment methodology is applicable for analyzing any global sector, regardless of the current macroeconomic environment.

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to identify their differences, spot opportunities, and avoid major pitfalls.

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Given the vast market landscape and diverse geographic operations, it is vital to maintain a global perspective when investing in the Consumer Discretionary sector. This invaluable resource provides the tools that can help you understand and analyze opportunities both in the United States and abroad within this diverse sector. For more information, visit www.consumerdiscretionary.fisherinvestments.com.

About Fisher Investments Press

is a graduate of UC Berkeley. Fisher Investments Press brings the research, analysis, and market intelligence of Fisher Investments’ research team, headed by CEO and New York Times bestselling author Ken Fisher, to all investors. The Press covers a range of investing and market-related topics for a wide Jacket Design: Leila Amiri Jacket Images: © iStockphoto

easily accessible primer to economic sectors, regions,

you make more informed decisions within the

at the Haas School of Business at UC Berkeley. He is also the Editor in Chief of MarketMinder.com. Teufel

primarily for investing in global stocks. Each guide is an

characteristics. Using the framework detailed in this book, you can learn to be better equipped

audience—from novices to enthusiasts to professionals.

CONSUMER DISCRETIONARY

to joining Fisher Investments, he worked at Bear

This reliable guide can help you in making top-down investment decisions specifically for the

Consumer Discretionary stocks and which Consumer

on

a Co-President and the Director of Research. Prior

provide individual investors, aspiring investment

professionals, and students the tools necessary to

your guide, you can gain a global perspective of the

ERIK RENAUD is a Consumer Discretionary Research

he Fisher Investments On series is designed to

Discretionary industries and sub-industries have the potential to perform well in various environments.

Divided into three comprehensive parts—Getting Started, Consumer Discretionary Details, and

• An in-depth look at the global Consumer Discretionary universe, including automobiles, consumer durables and services, retailing, and media

• Tips and tools for security analysis and portfolio management

• A useful guide for investing in any market condition

Thinking Like a Portfolio Manager—Fisher Investments on Consumer Discretionary: • Explains some of the sector’s key macro drivers—like consumer spending, income, and employment • Shows how to capitalize on a wide array of macro conditions and industry-specific features to help you form an opinion on each of the industries within the sector • Takes you through the major components of the 12 subindustries within the global Consumer Discretionary sector and reveals how they operate • Offers investment strategies to help you determine when and how to overweight specific industries within the sector • Outlines a five-step process to help differentiate firms in this field—designed to help you identify ones with the greatest probability of outperforming

Foreword by New York Times bestselling author Ken Fisher

ISBN: 978-0-470-52703-0

(continued on back flap)