Sunday Edition: Would John Templeton Buy This Sector?

April 16, 2017

Sunday Edition: Would John Templeton Buy This Sector?

When a market is as overvalued as the S&P 500, it’s best to be defensive, rather than being 100% invested, trying to eek out every last drop of potential gain.

I don’t care if the market moves another 10% or even 15% higher based on momentum.  When you compare the potential for another 5% to 15% upside against the risk of a 50% or greater crash, it seems like a foolish move to me.

At the top of a business cycle (we are there now), the most successful investors will typically hold much larger than normal cash balances and only commit new money to sectors which are truly undervalued – and trading at a point of maximum pessimism with a nice margin of safety.

One such sector, in my opinion, that I believe is reaching a point of maximum pessimism, and provides a good margin of safety, is the retail apparel sector.

My colleague Sven Carlin recently wrote about the idea that a bad company or sector can make for a great investment – at the right price. And likewise a great company can make for a bad investment at the wrong price.

This advice is echoed by investing great Howard Marks in the following quote: “I’ve said for years that risky assets can make for good investments if they’re cheap enough. The essential element is knowing when that’s the case.”

Sven also wrote about the retail sector a few weeks back, and how it makes for a poor long-term investing opportunity. I completely agree with his points about retail being highly competitive and subject to fickle fashion trends that are constantly being replaced by new trends.

Retail doesn’t offer enviable capital efficient companies with a strong economic moat that qualify for Buffett’s preferred holding period – which is forever.

However, as cheap as certain retail apparel companies are, I believe they make for a great trading opportunity, and even an intermediate investing opportunity, with a hold time of 1 to 3 years. But there are risks, and certain companies you’ll want to avoid completely, which I’ll discuss shortly.

But I first want to address the idea of committing new capital in such an overvalued market.  Generally speaking, as measured by the retail ETF XRT, the entire retail sector is still too overvalued in my opinion.

And even though XRT has already started to correct, where the S&P 500 continues to make new highs, it is still subject to a more significant correction should the S&P 500 turn down, which is only a matter of time.

But I believe retail apparel companies are at or near long-term fundamental bottoms and should provide safety and preservation of capital even if the overall market turns down. And I’m committing my own personal capital accordingly.

Does that mean I believe the retail sector will move counter-trend to the S&P 500? Not necessarily.

Let’s suppose that the general market moves another 10% to 15% higher from today’s levels.  Because the retail apparel sector is so undervalued, it’s possible the share prices of the best companies experience an even larger move to the upside, maybe as much as 25% to 50%.

If the S&P 500 were to then start a new long-term bear market, maybe the initial correction is 15%, before experiencing a bear market bounce (markets don’t move in a straight line).  During that drop and subsequent bear market rally, it’s possible retail apparel companies dron’t drop as much or even trade sideways, and then move to higher highs during a bear market bounce in the overall market.

I realize this is all conjecture, but this is ultimately how different sectors can, more or less, move in “sync” but still end up with vastly different returns. And why I believe there is a decent margin of safety in retail apparel.

Therefore, when a market is cheap and offering great long-term return potential, it should be bought no matter what your opinion is of the rest of the market.

Now, in the spirit of being defensive, even though you may choose to initiate new positions in an undervalued sector, even when you believe the market is extremely overvalued, you may choose to take a smaller than normal position, so that if you normally allocate 5% to 8% per position, maybe you only allocate 3% to 5%.

So what has caused the share price of certain retail apparel companies to drop by as much as -50% to -75% over the last 3 to 5 years where the general market has gone straight up?

In a word, Amazon.

I believe the retail apparel space crashed due to overblown fears of a “worldwide Amazon takeover,” and the fact that many of the big “mall anchor” companies, such as JCPenney and Macy’s, are having massive store closures.

Evidence that the retail apparel space is reaching a point of maximum pessimism was provided in an April 5th Bloomberg article:

…a growing number of hedge funds, which have wagered against mall properties through CMBX derivatives indexes that tracks commercial mortgage-backed securities. The prevailing theory is that failing brick-and-mortar retailers will mean higher vacancies and bankruptcies for mall operators, with losses inflicted on CMBS holders. But the trade has become so crowded in recent weeks that betting the index will drop even further is a longshot, Citigroup said in an April 5 report.

Source: Bloomberg.

This trade (a bet on the demise of the mall) is akin to what hedge funds did back in 2007 when they used derivatives to bet on a fall in mortgage backed securities (MBS). Now they are betting on a fall in commercial backed mortgage securities (CBMS).

Do I believe “betting” on mall closures will work out in the end? Probably so, and the “mall anchor” stores such as Sears, Macy’s, JCPenney, Dillard’s, and Nordstrom have a tough road ahead that many won’t surviving.

That’s not to say that all of these “mall anchor” stores will close their doors forever, it’s just that I believe there are better opportunities to be had as a result of the “maximum pessimism” in the entire sector.

However, because retail apparel offers no economic moat, you should focus on companies with no to low debt, that are capital efficient, that have seen smaller margin erosion throughout the downturn, and are making some headway into selling through their online channel.

And focus on companies whose brand still remains relevant among millennials ages 20 to 30 and whose apparel line is among the current growing trends such as the athletic leisure wear trend – for example.

The opportunity in retail apparel isn’t about buying great companies at good prices, it’s about buying good companies at great prices, but because of the fickle nature of fashion, don’t overstay your welcome.