Frank Thoughts
Frank Boland
February 17, 2010

Today we share with you yet another edition of "Frank Thoughts".  In this edition, Frank recalls back to his days as an analyst at Lehman Brothers in the early 1980's when he covered K-Mart stock.  At the time, discount retail stocks were out of favor but came storming back to perform exceptionally well during the ensuing bull market.  While Frank feels retail stocks are poised to perform well again this time around, will that be the case this time around for discount retail?  In today's day and age, probably not....

“THE TIMES THEY ARE A-CHANGIN”

  It had been a long day and it was nearly six o’clock.  I was eager to get home for dinner.  Yet again the phone rang.  With my coat on, I reluctantly reached down and picked it up.  “Frank Boland,” I answered.  “Hi Frank!  It’s Fred Wintzer!,” bubbled an ebullient Lehman Brothers security analyst.  “You’ll never guess where I’ve been.  Troy, Michigan!!!”  I slumped down in my chair.  Fred was our retail analyst and there was only one company he might possibly want to see in Troy, Michigan ---  K-Mart, at the time, the country’s largest retailer. 

 

  It was towards the end of 1982 and we were mired in a horrible two-year recession.  K-Mart, a $5.00 stock, denied rumors almost daily that the company was going out of business.  But Fred was definitely cranked-up and it was the end of the day, so I quietly listened.  “Frank when I walked into the CFO’s office he got out of his chair, walked around to the front of his desk and hugged me.  Hugged me!” he shouted.  “He told me I was the first security analyst he had seen in six months!”  Fred now had my complete attention.  We were both contrarians.

  Consumer spending, then as now, accounted for two-thirds of the economy.  K-Mart alone represented nearly 4% of GDP.  So in my mind, there couldn’t be an economic recovery without K-Mart benefiting.  The first month the leading indicators turned up, I bought the stock.  The company did not go out of business and the stock tripled.

  Our current recession, twenty-eight years later, is also two years long and arguably worse than the 1981-1982 experience.  Certainly the unemployment rate is higher.  Given that we are, yet again, emerging from a bad recession it seemed reasonable to look at the new K-Mart --- Wal-Mart.  After all consumer spending is, by some estimates, now as high as 70% of the economy.  So, as an investment strategy, buying the biggest discounter should work even better.  One problem:  Wal-Mart, in our research, was a sell!  Amazingly so were other major discounters.  Dollar Tree Stores, Kohls, Yum Brands, BJs Wholesale, Costco Cos., McDonald’s Corp., Burger King, Family Dollar Stores etc., were all sells.  As you may know, we use long-term relative price strength analysis in our research process.  So it is possible these retailers could go up on an absolute basis but still under perform the market, the S&P 500.  What could it possibly mean?  My mind quickly went to the negative implication. 

      But then we looked at the opposite of discount retail --- consumer luxury goods.  Amazingly, these stocks were universally positive!  Tiffany &Co., Ann Taylor Stores, Liz Claiborne, Marriott Hotels, MGM Mirage, Nordstrom, Saks International, Talbots, Wynn Resorts, Cheesecake Factory, Chico’s, Coach, Polo, Ralph Lauren, Starbucks, Wholefoods Market, Williams–Sonoma etc. --- all positive.  Huh?  It defied common sense and my 45 years of being in the investment business. 

  Of course, it begs the question, what could possibly be different now from nearly 30 years ago?  Human behavior is certainly unchanged.  Yet this experience is totally different.  Why would that be?  And then a possible explanation occurred to me.  People are the same, but the economy is different.

  Thirty years ago we were a manufacturing economy.  Today we are primarily a service/knowledge- based economy.  The “big house on the hill” in our home town in the past was primarily owned by a man who manufactured a tangible product.  Today he’s more likely to own or create intellectual property.  The brilliant business consultant, Peter Drucker, foresaw this evolving change in our economic development decades ago.  In this recession it has had a profound effect on manufacturing states such as Michigan and Ohio.  But it has been an inexorable development in our economy for over 30 years.  At the end of the last century we were concerned with our massive trade imbalance with Japan.  Now it is China.  Year-by-year we increasingly outsource our manufacturing and have become an intellectual economy.  This alone may be the reason technology stocks have outperformed the broad market off the March low.

  However there are unfortunate near term social implications to this development.  Intellectual property development is more egocentric.  It does not employ anywhere near the same number of people that a manufacturing economy does.  Undoubtedly many of the jobs lost in this past recession will not be coming back.  This is very different from 1982 when laid off automobile workers would be recalled after inventories were worked off.  K-Mart’s business would quickly pick up creating and reinforcing a positive feedback loop.  That strong organized labor economy no longer exists.

  Moreover, this 30-year evolving “intellectualization” of the U.S. economy has the unintended consequence of widening the gap between the “haves” and “have-nots” --- which brings us back to Luxury Goods vs. Discounters.  In 1982 we were solidly a manufacturing economy.  Bill Gates was not the richest man in the world.  Labor unions were a significant political force.  Consider how much has changed.

  The stock market sell off in 2008 and 2009 had nothing to do with the stock market.  It was a debt crisis.  Hedge funds were given massive margin calls by banks and brokerage firms who also owned Collateral Debt Obligations and knew full well they were, in many cases, worthless.  Certainly at the least unsalable!  The easiest-to-sell assets were stocks.  And so it began and eventually hitting a margin liquidation low –down over 50% in March 2009.  A ten million dollar stock portfolio dropped to five  million making rich people feel suddenly poor.  And they stopped spending --- which led to the recession.  But with the margin selling gone, the market is up 60%.  The top one percent are now back in the economy and spending on Luxury Goods.  As Bob Dylan once sang long ago, “The Times They Are A-Changin.”
 

FRANCIS PATRICK BOLAND

2-16-10

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