Everything seems to be looking up in the markets at the moment, at least it does from my particular vantage point. My portfolio has risen pretty relentlessly so far this year and is almost back at its all time highs, something I didn’t expect to happen nearly so quickly back at Christmas time. Many of the other investors I follow on Twitter have also been posting high-teen YTD returns or better (well done if that’s you). As I mentioned in my recent portfolio review, I think the macro picture currently seems fairly benign for investors in high quality equities. What could go wrong I wonder?
High equity valuations are probably what give me the most pause for thought at the moment. One narrative is that equity valuations have now grown to excessive levels across the board, fueled by Central Banks’ reckless addiction to Quantitative Easing. Excessive valuations would imply that a market crash was more likely or that it would be more severe when it came. The current bull market has certainly been going on for quite a while, so this seems like a natural concern to have.
I’m not in the camp that believes we are in a QE-fueled assflation (asset price inflation) bubble. For one, I’m not convinced that monetary policy has been overly loose given the deflationary environment we found ourselves in following the Financial Crisis. We are yet to see much inflation in consumer prices or signs of an over-heating economy. The QE assflation narrative also seems strange if you look at current stock market valuation multiples. Fundamentals seem to have largely kept up with valuations (aided recently by the US tax cut). The current trailing PE ratio for the FTSE 100 is around 15 and the S&P 500 is around 21. These are on the high side but not all that far from their historical averages.
Of course, the concern with taking these figures at face value is that you fall into the trap of over-extrapolating the trajectory of the current business cycle, ignoring the risk that it will turn, depressing corporate revenues and margins and making everything suddenly look a whole lot more expensive. The trouble is that it’s very hard to anticipate this well i.e. ahead of the stock market. Unless you have some special insight I don’t think it is worth trying. A better approach is to ensure your portfolio has enough exposure to defensive businesses that will fare better when the next downturn inevitably does occur. For what it’s worth, I don’t think there is good reason to believe a major recession is imminent. It’s easy to see that the global economy is slowing down. The more pertinent question is whether this is likely to be a temporary blip or the start of something more serious.
I’m more concerned about the widening ‘valuation spread’ between high quality growth stocks and lower quality value stocks. This is quite apparent from the extent to which the valuation multiples for the high quality shares on my watchlist have expanded. While I would have felt comfortable suggesting that nearly all of these businesses looked undervalued back at the start of 2016, now most look fairly valued rather than obviously cheap and some seem downright expensive. On the other hand, valuations of more cyclical value stocks haven’t changed much. One of the main building blocks of my investing strategy is the idea that the valuation spread is generally much too narrow, as short-sighted investors underestimate the significance that more certain long term compound growth has for the valuations of high quality businesses. The fact that this valuation spread has widened substantially over the last few years suggests that any excess returns from my high quality focus are not going to be as big as they have been. Individual stock-picking is becoming more important so I’ll be playing closer attention to valuation in future trades.
I’m a bit late in updating on the following trade, made three weeks ago now: I sold Craneware for a small profit and bought JD Sports. Part of the rationale for this trade was that JD Sports was more reasonably valued than Craneware and part that it had stronger momentum. My timing seems to have worked out pretty well so far, with JD Sports already up 25% on my initial purchase.
I’m sure most readers will have heard of JD Sports. It is of course a sportswear retailer with a focus on footwear. It has an acquisitive business model, purchasing many smaller and sometimes struggling sportswear retailers at very reasonable prices and turning them around, sometimes rebranding them. Its most recent acquisitions have been Footasylum in the UK and the Finishing Line, which it intends to use as a stepping stone for entering the US market. What you may not know is that JD Sports has been the most successful investment in the FTSE 350 over the last 10 years, its share price having risen by more than 30 times at a compound growth rate of more than 40%. It’s now on the verge of entering the FTSE 100. Pretty good going for a high street retailer!
Given this track record, it’s remarkable that I haven’t been able to make much money in JD Sports, despite having been a keen admirer of the business for some time and making a couple of ill-timed trades. It’s one of my ‘nemesis’ stocks. Hopefully this time my investment will come good!
- Business economics: retailing trainers is not a business that you would expect to be particularly profitable but JD Sports seems to do very well. It has decent operating margins of about 9% and has delivered consistently high returns on capital of at least 25%. I’m particularly impressed that it has achieved this while also making a large number of acquisitions that have rapidly accelerated its growth.
- Track record: as mentioned above, the track record of consistently and rapidly growing revenues, profits and share price is astounding. Two additional points from its track record stand out to me. One is that it was relatively unscathed by the Financial Crisis. The other is that it does not appear to have been affected at all by the shift of retail to online, unlike the vast majority of other retail businesses I can think of.
- Competitive advantage: questions about its competitive advantage have always been my main hang up about investing in JD Sports. My approach to looking at competition is to always start by thinking about the characteristics of the market, before then considering the merits of the specific players. Generally this approach means I steer well clear of retail markets. Barriers to entry tend to be very low, customers find it very easy to switch to alternative suppliers and consumer tastes can evolve fairly rapidly. Not owning the IP of the products being sold can also expose retailers to pressure from their suppliers in negotiations, to the extent that the suppliers have access to alternative distribution channels. So what do I think could be exceptional about JD Sports? It seems to manage its retail brands very well. The quality of customer experience at its main fascia (i.e. JD Sports) seems higher than that of competitors. This matters to both its customers and the high quality sports fashion brands (e.g. Nike) who supply it. Part of its strategy is to leverage this quality and its existing scale to negotiate exclusive deals with suppliers, creating something of a virtuous circle and barriers to entry for others who may seek to challenge it. I think there may be some legitimacy to its claim of being the ‘undisputed king of trainers’. Overall, it’s a case of the track record trumping my generic concerns about it being a high street retailer.
- Growth prospects: the growth prospects seem very good. JD Sports has its sights set on further international expansion and there are plenty of opportunities for it to do so. There is quite a bit of risk involved in entering new geographic markets so it’s not all sunshine and roses. The US is a notoriously difficult market to enter.
Momentum is excellent with the share price breaking out to new highs on publication of its results this week. At the time of my purchase three weeks ago the market was already responding positively to its January trading update and news of its Footasylum acquisition. The valuation seems cheap given JD Sports’ track record and growth prospects, even accounting for the potential risks involved in its continued expansion.