The Gannon On Investing blog began on December 24, 2005 with three short posts. What was the subject of my very first post?
American Eagle (AEOS). This is how I began that post:
Generally, I don’t like investing in retailers, because it is nearly impossible to find one with a durable competitive advantage. I do, however, like to invest in companies generating tons of truly free cash flow and consistently earning good returns on invested capital while maintaining a pristine balance sheet. When one such company is priced at less than a dozen times earnings (and a part of that price is attributable to the cash in its coffers) my heart begins to patter.
The object of my affection: preppy teen retailer American Eagle.
I'm revisiting this post, because things have changed. Well, one thing has changed – the price of American Eagle's shares. At the time I wrote the blog's inaugural post, shares of American Eagle traded at $22.02. Today, they stand at $43.78.
That's almost a double. But, not quite – it's actually an increase of 98.82%.
Needless to say, my view of the stock has changed. The company's shares no longer represent an especially attractive opportunity.
A recent post at Focus On Value mirrors my own thinking (both then and now). I have no special insight into American Eagle as a business. I simply thought it was a cheap stock – yet another victim of the often irrational pricing of teen retailers' shares in the stock market.
AEOS-PSUN-ANF-ARO ytd comparison chart:
As you can see in the above chart, American Eagle's three publicly traded "peers," Abercrombie & Fitch (ANF), Aeropostale (ARO), and Pacific Sunwear (PSUN), have greatly underperformed American Eagle during 2006. Therefore, the 98.82% gain is clearly not the result of a multiple expansion or change of sentiment within the U.S. equity market as a whole or the teen retailer group in particular, but rather a reassessment of American Eagle's relative value. The company's share price has greatly increased both in absolute terms and relative to its peers in particular and stocks in general.
While I don't normally discuss shorting stocks on this blog; I can't ignore the obvious opportunity presented by the existence of such mispricings. Clearly, exploiting such "relative bargains" is a field of activity that might be appropriate for some value investors – especially as a complement to other (more concentrated) investment operations.
In situations such as the one that existed on December 24, 2005, it is possible to purchase an issue that is especially attractive on a relative basis (but would be inappropriate as a large, long-term position in a concentrated portfolio) by shorting a relatively expensive peer of comparable (or lesser) quality.
For instance, in this case, you could have shorted Abercrombie & Fitch (which ironically had been something of a "relative bargain" a few years earlier when investors had soured on that stock). During 2006, such a multiple contraction "hedge" would not have improved your results. Simply purchasing shares of AEOS would have worked best.
However, some investors may feel more comfortable hunting for issues that are wildly mispriced relative to one another rather than having to consider whether price-to-earnings multiples across the market or within a particular group will expand or contract in the months and years ahead.
In other words, some value investors may prefer to focus on the micro picture where the principles of value investing are easiest to apply. Generally speaking, the principles of value investing are much more difficult to apply on the macro stage. As a result, some investors may wish to avoid such macro considerations entirely. The use of relative bargain pairs can help reduce the importance of macro considerations in the investment process.
For various reasons (which I won't go into here) I don't like this approach as the guiding strategy for an entire portfolio. But, I do think it has a place in the repertoire of value investors with a natural inclination toward such operations, especially as it may provide fertile hunting grounds at precisely the time when the rest of the investing landscape is barren.
Here, I should note the biggest problem with employing this strategy in a situation like the one described above is that the group may not have a lot of clearly overpriced issues to choose from (e.g., ANF wasn't a particularly attractive short on December 24, 2005). However, many groups do offer interesting "pairs" from time to time.
Looking for such pairs is a reasonable pursuit for a value investor to undertake. However, he must go into the operation understanding that his goal is to find additional investment opportunities to help him round out his portfolio. As part of a diversified group operation, such pairs offer a sufficient margin of safety. They are likely to be most attractive when more conspicuous bargains are scarce. So, in that sense, these pairs do help maintain an evergreen portfolio of sorts.
What the they don't do (and can't do) is guarantee excellent returns regardless of wild swings in the broader market. A portfolio made up entirely of such relative bargain pairs would not be fully insulated from the expansion and contraction of price-to-earnings multiples across the market, because such bouts of optimism and pessimism are often accompanied by a widening or narrowing (inverting, really) of the quality spread among common stocks.
Sometimes, the market is so irrational that the shares of more expensive, lower quality businesses can actually outperform the shares of lower priced, higher quality businesses – for a time. In other words, a portfolio invested in such pairs is not fully insulated from market-wide bouts of undue optimism or pessimism. In fact, such a portfolio may be exposed to other market-wide risks that are not immediately obvious.
However, if considered for the right reasons, I think such pairs have a place in the value investor's repertoire.
There's more than one way to skin a cat. As a result, the ability to identify and exploit such relative bargain pairs (an underpriced issue and its overpriced peer) is not necessary to achieve investment success. But, it's a useful skill to have – and a useful operation to consider, especially for investors who normally maintain highly concentrated portfolios that are difficult to replenish during market peaks.