High Conviction: A Footwear Company That Runs With Generation Y

| About: LaCrosse Footwear, (BOOT-OLD)

Logie Cassells (at right, top) and Jamie Moye (at right, below) are the principals of Beacon Asset Managers based in Chester, Nova Scotia. The company is a subsidiary of Beacon Securities Ltd., and offers independent investment services to financial institutions.

The company’s “3 Beacon” research approach focuses on three disciplines – demographics, valuation and sentiment – to discover undervalued equities, the performance of which are tracked in its model Beacon Master Portfolio. Cassells and Moye report that the model portfolio is showing a return of more than 75 percent since its December 2008 inception, representing more than 50 percentage point outperformance of the S&P Global Index ETF (NYSEARCA:IOO), which is up about 18 percent for the same time frame.

We recently had the opportuntity to ask Cassels and Moye about their current outlook on the market, their investment approach, and their single highest conviction holding at this time.

Did the market recovery of 2009 surprise you?

What a difference a year makes. At this time last year the vast majority of Wall Street pundits had adopted en masse the “nattering nabob of negativity” persona to warn us of the impending financial Armageddon. In hindsight this should have been expected. As noted by French philosopher Arthur C. Pigou: “The error of optimism dies in a crisis, but in dying it gives birth to the error of pessimism. This new error is born, not an infant, but a giant.”

To the surprise of many, but not all, the market recovery has been very similar to the eight previous recoveries since 1926. Near the lows the financial experts proclaim that the world is ending, the general public takes fright and sells everything, and floods into “low-risk” cash or bonds that return practically nothing, and promise never to return to equities again. This time investors can hardly be blamed for their behavior, as they were expecting early retirement but instead received the worst decade of returns since the 1930s. However, at or near the final lows investors always forget what ultimately lies at the very bottom of Pandora’s Box. And that is, hope.

Has the market recovery been different this time?

The market recovery since last March has been “textbook” in that the market has continued to climb a wall of worry. Having spent nearly two years slipping down the slope of hope, small caps outperformed large caps, stocks priced to extinction at the lows roared back to life, equities outperformed bonds and those sectors geared to the recovery led the way back up the hill of worry.

We believe that last March marked the start of a once-in-a-generation opportunity to invest in equities, and that this opportunity (with the odd speed bump along the way) is similar to those golden periods of equity returns experienced from 1939 to 1967 and 1974 to 2000.

What are your expectations for markets through the rest of 2010?

We expect the trend for stock prices in 2010 in general to be up; however, at times it could be bumpy (as the Ned Davis Research 2010 composite maps out). We continue to favor those sectors that are geared to the economic recovery, and the ever-growing consumer demand of Generation Y.

In managing exceptions in terms of what type of returns to expect in 2010, we turned to O’Shaughnessy Asset Management’s (OSAM) research in their January 2010 note. It found that the average return in the first year of a recovery following a severe bear market is 46 to 61 percent; the second year, 14 to 15 percent; and the third, 1 to 3 percent. Therefore, it would be prudent to lower our expectations for the year and expect the market to return about 14 percent, which would give the S&P 500 a target of about 1300.

This sharp pullback from mid January has corrected many of our concerns about extreme optimism, and we now expect markets to recover their footing. In many ways investors, including us, sometimes get caught up with trying to fine tune the market over the short term to such an extent we forget the forest for the trees. What we should be doing is spending less time watching what the market averages are doing, and more time focusing on the discovery of undervalued potential “Super Stocks” that will be supported by generational demand and that sell for 75 cents or less on the dollar, or a price to sales ratio of 0.75 or less.

And you determine “generational demand” through demographics?

Yes. Demographics is one of the three key investment tools we use to discover undervalued assets – and to avoid over-believed and over-priced assets. Demographics gives us a longterm, or decennial, global picture of emerging and declining consumer demand. On the macro level we believe today’s weight of evidence supports a “generational opportunity” in equities over the next 20 years similar to ones that emerged in 1939 and 1974 as shown on this chart.

The G.I. Generation – born 1905-1924 and more than 50 million strong – spurred the 1939 generational opportunity, while the much larger Baby Boomer generation – born 1945-1964 and more than 75 million strong – spurred the opportunity that emerged in 1974.

By examining those previous opportunities we can manage our expectations during the first eight years of this current opportunity. In those two previous ones, investors had eight years to patiently accumulate the next generational winners before entering secular bull markets that lasted nearly 20 years and saw more than 10-fold returns from 1947 to 1967, and more than 20-fold returns from 1982 to 2000.

So you believe the current generational opportunity will be driven by Generation Y?

Yes. Generation Y is bigger than the Baby Boomers, and we believe they will prove to be economically more influential, too. But we also feel that the Baby Boomers, unlike predecessor generations that rapidly aged out of the consumer market, will continue to be a significant consumers, as early indications seem to indicate that Boomers may redefine what it means to be “old.”

Can you describe your other two investment tools?

Valuation and sentiment. For valuation we rely on the uncommonly used metric of price to sales ratio. This is less available for manipulation and quickly shows investors what the market is willing to pay for a dollar of a company’s sales. The key advantage of using sales rather than earnings is that earnings can widely fluctuate or be manipulated. The other advantage of using the P/S ratio is that it reminds you of the risk you are taking for the perceived return. If you are paying $7 for every $1 of sales of the latest hot stock or theme, it reminds you to consider why you are paying so much, and to better consider what the likely returns may be over the next 3 to 5 years.

Sentiment allows us to gauge how over- or under-believed the market or a theme is. The simplest way to explain this is to borrow a quote from Warren Buffett: “Be fearful when others are greedy and greedy when others are fearful.”

So, these three tools help you find the “Super Stocks” highlighted in your reports?

Yes, we look for out-of-favor, under-believed stocks that are poised to benefit from generational demand and have P/S ratios below 0.75. For an historic example of how this works let’s look back at Nike in 1984. At that time investors who saw its value on a P/S of 0.3 and its potential to tap into the emerging generational demand of the latter half of the Baby Boom and first half of Gen. X, made off like bandits.

The shares between 1984 to 2000 rose from 48 cents to $36 (up 75 times), and its P/ S, or popularity barometer, rose from 0.3 to over 2.5 times. In common sense terms, new investors were prepared to pay $2.50 for every $1.00 of its sales because it was now a success. To be fair, since the year 2000 Nike has outperformed the S&P 500 (Nike up 140 percent versus a decline for the S&P 500 of 23 percent). However, investors in 2000 looking for further “Super Stock” returns from Nike should have been wise to the fact that a P/S of 2.5 would likely limit the chances of “super” returns.

In 2000, prescient investors using our approach would have sold Nike and rolled their profits into the next shoe wonder stock: Deckers Outdoor (NASDAQ:DECK) on a P/S of around 0.4. The shares rose 3,669 percent and were one of the top-10 performers of the last decade.

No shoe review would be complete without reference to Crocs’ (NASDAQ:CROX) Icarus-like flight to the sun and subsequent meltdown back to earth. The company came to the market in 2006 on a P/S of 1.4 (using 2007 sales) and quickly found investor favor taking the shares to a P/S of over 7.0 by late 2007. The shares rose over 5 times during this time and then collapsed nearly 90 percent to leave the shares unloved and on an undemanding P/S of 0.1. Not surprisingly the shares have recovered strongly (nearly eight times) from these capitulation lows, and currently sell on a P/S of 0.9.

OK, so what is your highest conviction stock position in your current model portfolio?

It’s hard to pick just one, but if pushed I guess we’re going to have to stick with shoes, and in particular, LaCrosse Footwear (NASDAQ:BOOT-OLD).

Most investors have probably never heard of LaCrosse, other than as a sport. But we believe in the attractive growth story of the company’s exciting footwear business, strong management, record cash in the bank, emerging generational demand for its products, and 3+ percent dividend.

LaCrosse seems very well placed over the next decade to see demand for its work and outdoor boots and shoes grow at a healthy rate as Gen. Y enters the workforce and leisure market. The company’s recent acquisition of Environmentally Neutral Design (END) will have a marginal impact on LaCrosse’s revenue stream in the near term; however, by the end of the decade END has the potential of being larger than its new parent.

END is a Portland-based outdoor athletic shoe manufacturer that focuses on sustainable footwear. The company was launched in 2007 by Ben Finlea and award winning footwear designer Andrew Estey, the former global design director for sport culture at Nike.

The company released its first products in August 2007 exclusively on the web (REI, Zappos, Rock Creek and Backcountry.com). This was quickly followed by a retail launch in early 2009, and its products are now available in 100 stores across the U.S., Canada and Japan. END’s light weight Stumptown shoe won best trail shoe debut by Runner’s World magazine in March 2009.

Major footwear companies have done an amazing marketing job over the last 15 to 20 years, convincing us that we need more high-tech design along with higher prices in our athletic shoes. However, END’s 12oz trail trainer (Stumptown) when ranked against the top five competing shoes represents a 35 to 59 percent reduction in complex shoe parts, and its next 10oz model will reduce glues and cements by 75 percent. The company’s ultimate goal is an 8oz trail trainer, whose light weight should also make the aging Baby Boomers happy.

A further plus in END’s strategy to change the footwear, as well as the “sustainability,” industry is on the issue of price. Today in the U.S. “sustainability” and its first cousin, “organic,” are expensive. It seems that for the majority of us in North America if we want to buy wind powered energy at home, organic produce at the market, or a bamboo shirt then we’d better be prepared to pay anywhere from 20-70 percent more for that product versus a comparable “non-green” everyday option. We agree with END’s management that this is not a very sustainable way of doing business. If END’s strategy is successful in demonstrating to people that they can actually get a better shoe that is actually a few dollars less and is good for the environment it could represent the start of a paradigm shift, or tipping point, in organic premium pricing. No shoe in END’s lineup is over $100–its 12oz will retail for $80, the 10oz for $70, and the 8.5oz for $60. These prices still deliver great margins to the retailer, and very good ones to END, and ultimately LaCrosse.

We believe END could transform the athletic footwear market with its products and that eco-aware Gen. Y will love them. We look forward to following this exciting story, and should also note that investors are buying this company’s potential at 68 cents on the Dollar (P/S 0.68).

What other emerging generational opportunity equities are you finding?

There are plenty of them out there. Among those that have caught our attention are Collective Brands (NYSE:PSS), Pacific Sunwear of California (NASDAQ:PSUN), Boston Beer Co. (NYSE:SAM), and K12 (NYSE:LRN) for Generation Y; and NuSkin Enterprises (NYSE:NUS) and John B. Sanfilippo & Son (NASDAQ:JBSS) as aging Boomer plays.

John B. Sanfilippo & Son – nuts?

Yeah, nuts. The most recent health food story. Boomers are going to eat them up.

Thanks so much for describing your process, thesis and investment ideas, Logie and Jamie.

Our pleasure. Happy to contribute.

Addendum from Jamie Moye, 3/2/10: Readers have informed us that LaCrosse plans to discontinue the END line of footwear as a stand-alone brand and leverage the END platform of innovative and lightweight designs under its LaCrosse and Danner lines and distribution channels in the Fall of 2010. This does not change our opinion of the company as expressed in the above interview, and we trust that LaCrosse will maintain END's eco-friendly design, sustainable production methods, and competitive pricing when the line is offered as part of the LaCrosse and Danner lines of footwear.

Disclosure: Beacon Asset Managers is long BOOT, PSS, PSUN, SAM, LRN, NUS and JBSS.

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If you are a fund manager and interested in doing an interview with us on your highest conviction stock holding, please email Rebecca Barnett.

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