Dr. Kellegro will now dissect an article that came out today describing one of my favorite shorts of this generation – TRLG - as “The Greatest Stocks of the Next Generation”. The link is here http://www.fool.com/investing/high-growth/2010/01/20/the-greatest-stocks-of-the-next-generation.aspx. The article is written by Todd Wenning.
The Motley Fool website, for one reason or another, has a tendency to run these types of screens using a predefined set of fundamental measures. They then come up with titles that make you think you are stumbling on the next Microsoft. I see it week in and week out…”The Greatest Stocks of the Next Generation” is one of the latest. I usually just scan them with a befuddled sense of amusement and typically feel sorry for those who choose to believe they will actually make money over the long term by paying attention to these lumps of coal disguised as gems. However, when one of my top short sale candidates is mentioned, I feel it as my obligation to stand up, expose my sword and prepare to carve up whatever arguments they make. So let’s go through it and carve it up for what it is.
About mid-way through the article we find the following quote from a book that I would warn you against reading for fear of turning you into a mindless robot:
In his recently released book It’s Not What You Sell, It’s What You Stand For, Spence, whose agency helped companies as diverse as Wal-Mart, Southwest Airlines, and John Deerearticulate their purpose, cited a study by Jim Collins and Jerry Porras that found that “organizations driven by purpose and values outperformed the market 15:1 and outperformed comparison companies 6:1.”
Subjective, wouldn’t you say? Organizations driven by purpose and values? Are we standing at a podium in the middle of heartland trying to get a group of mill workers and tobacco farmers to vote us into office? How do you define purpose and values when it comes to an organization? You’re telling me that True Religion falls under the category of a company with purpose and values? Does that purpose and value have anything to do with making mouse-dicked 55 year old men feel like they are 25 again. Or is it to make testosterone driven young men from the suburbs of America have a pair of jeans that actually matches their full sleeve of tattoos on both arms? It’s cool to act like you’re a fighter in the UFC until you actually get into a fight and realize you are not, with your $200 True Religions torn on one side and your tough guy tattoo of a skull with dragons flying out of its eye sockets looking more like a cartoon. Purpose and values?!?! Now I know the article doesn’t specifically cite True Religion as a company with purpose and values, but it tells you to start your search with a company like TRLG because of fundamental value X, Y and Z. It’s nonsense, but I suppose it builds a website.
What is so dangerous about a writer recommending these types of investments - especially in the retail space - based on X,Y and Z fundamental specs, is that during the typical life cycle of a specialty retailer, like TRLG, at its price per share peak is where you will see its best numbers. In the article, it tells you to look for companies that have ROE of greater than 15%; gross margins that are greater than 35%; and strong sales growth. Let’s go through these one by one.
In TRLG’s case its gross margin sits at 61%, the highest of any company on the list. This is my cue to say congratulations to all those who bought a pair of these, YOU GOT RIPPED OFF! That’s all this high gross margin number tells us…their markup on these jeans versus their cost of manufacturing is, on the surface, appealingly high to the investor. However, look below the surface and you will see that the consumer is receiving no value for the money spent. And then face the simple realization that consumers are only willing to be robbed of value in the midst of trends…whether they be cultural trends, ideological trends, or in this case, fashion trends. There is something about being a part of that herd that allows individuals the ability to disregard the value of money in the exchange of what is seen as a more valuable, must-have accessory. This is the phenomenon that has occurred (yes, I say has, because it has seen its peak) with True Religion. There is no value for the consumer in the brand. As consumer realize this gross margins will plummet.
Next on the nonsense fundamental screen is “strong sales growth”. There isn’t much to say here. When a brand is going through its “recognition phase” it will sell. Its sales growth will look outstanding due to the fact that it has come from nothing and built itself into something. If I opened a condom factory and it was discovered that my condoms magically made the penis dispense $100 bills for a period of 40 minutes, my sales would boom for a period of time as my condoms became recognized. This is the recognition phase for my brand of condoms. Once the value of the US dollar was eventually completely destroyed as a result of every man in the world printing dollars in his bedroom, my product would then be outlawed and the companies sales would decline, as we exit the recognition phase and enter the reality phase. At its peak, every company will experience “strong sales growth” and as a result it will come up on this nonsense screen.
Next up we have “consistent ROE of greater than 15%”. This fundamental metric is completely useless when it comes to measuring specialty retailers due to their highly cyclical nature. Again, when they are going through their respective recognition phases, their ROE will be at its peak. As it exits its recognition phase due to the inherent fickle nature of the consumer in today’s developed world, their ROE will decline dramatically.
Let’s forget about the screen completely and focus on pure odds. I’ll ask you a question. In 2019, who will win the Superbowl? Picking the next Starbucks or Wal-Mart is similar to picking the winner of the Superbowl at the end of this decade. With all the variables involved it is nearly impossible to make an educated guess. Similarly, it is nearly impossible to pick stocks that are midgets (sub $5 billion market cap) now, with the hopes that they will be giants ($50 billion plus market cap) at the end of this decade. There are too many variables involved. It is much easier to short hope than it is to catch that one feather in the wind that actually makes it to the top of the mountain. For every one feather of hope that floats on forever, one hundred of them will get stuck in a bush, tree or someones hair. You have to go with the odds and forget about the long shot, pie in the sky fantasies of turning out like that old lady in Nebraska that bought Microsoft at 35 cents.
A foolish motley fool indeed. Entertaining article Mr. Wenning, but it’s just that, entertaining…with no real investment applications whatsoever.
Dissected for all to see…Dr. Kellegro…day 17.
Disclosure: Short TRLG and looking to get shorter