22 May Macy’s—A Retrospective
It has been a common theme over the course of my career that nearly all of our key investments evoke a cringe when mentioned initially. To make big money and outperform over the long-term, you have to have a few attributes going your way.
• Firstly, you need to be patient and let time do its thing. As Charlie Munger says, “The big money is in the waiting.” The vast majority of market participants are concerned with the next quarter or year, meaning that if the outlook is cloudy over that time horizon, but looks brighter further out, one can engage in a time arbitrage.
• Secondly, you must be willing to go against the crowd if the facts tell you that it is the right thing to do. Market psychology is one of the most consistent patterns to bank on, and by scouring areas where others fear to tread, one can find far greater opportunities than by simply following the crowd.
• Thirdly, mean reversion is one of the most powerful forces over the long-term. Markets overshoot on the way up and on the way down. The investor that understands that trees don’t grow to the sky, and that at some price just about everything is a buy, has considerable advantages over those that are governed simply by short-term price movements.
One recent example of an extremely successful investment was in the common stock and options of Macy’s (M). Hold Your Nose And Buy Macy’s-Tim Travis-It is virtually a consensus opinion that the best days of department stores are in the past. Just about all malls are supposed to be dying off, meanwhile Amazon is going to destroy everyone in perpetuity. In these opinions, there are a lot of credible facts that are taken too far. Most department stores are shrinking or going away. Malls are having to reinvent themselves into entertainment destinations, as opposed to merely a collection of apparel stores. Online shopping still accounts for just over 10% of overall retail sales so there is still a huge need for conventional retail, the key is having products that people want and need. Companies that tap into that vein will thrive, while those that fail to adopt will struggle.
Our investment in Macy’s was based on a few key attributes. The price that we were paying for the entire company was likely less than value of just its real estate, giving us the rest of the business for free. Unlike Sears for instance, Macy’s has been consistently profitable and generates considerable free cash flows. When we bought the majority of our stock, the dividend yield was between 6-8%, so many market participants seemed to be betting that the dividend would likely be cut. Dividend cuts are often greeted by major stock declines, although over the long-term it may be in the best interests of shareholders. We didn’t think it was likely that the dividend would get cut, but even if it did as a way to deleverage the company at a more rapid rate, we would have been fine with it.
We also saw that Macy’s had some unappreciated operations such as Blue Mercury, which is kind of a smaller version of Ulta Salon, which has been one of the best growth stocks over the last decade. Blue Mercury has been growing rapidly and offers a wonderful investment opportunity within Macy’s. As it scales up, it should produce far more cash, or ultimately, could be spun-off a very high multiple. Lastly, Macy’s was taking all of the right steps to survive. It was reducing debt, monetizing some of the value of its real estate, and focusing on improving its operating efficiency.
Now it is about 1 year later, and the stock has doubled from its lows, yet most market participants probably didn’t notice. Not a ton has changed for the company as its earnings guidance was only increased by a small percentage, but it has become increasingly clear that the company is not in some death spiral like so many just assumed, because it fit in with the ongoing narrative about retail. Macy’s executed on reducing its inventory and protecting its margins. It followed this up with a strong Christmas and 1st quarter. Macy’s is not all of the sudden in some major revenue growth environment. Same store sales growth is expected to be between 1 and 2%. However, because the expectations implied in the price were so dire, just a simple reversion to the mean allowed for massive profits on the position.
At current prices, we view Macy’s as being fairly valued. If they execute perfectly, it can still do quite well. There are characteristics of the business and retail in general that we don’t like so we have been sellers over the last few days. One thing I don’t like about the company is that a large percentage of its profitability is tied to the credit card operation, as opposed to the core retail operation of selling products. Our investments in Macy’s consisted largely of selling puts that got us exercised at extremely cheap prices. We also bought a lot of stock outright and intertwined these purchases with covered calls that were way out of the money. Lastly, we had most of our sold puts expire worthless or exited after earning most of the profit, generating very large annualized returns.
For instance, one of our biggest put sales was selling the Macy’s $18 January 2019 puts for roughly $3.50 per contract. These options generated returns on maximum risk of roughly 24%, with annualized returns in excess of 40%, as we’ve been able to exit them far earlier than expected, due to the appreciation on the stock. While obviously attractive returns, one Monday morning quarterback might say we should have only bought the stock from those levels since it has appreciated so dramatically. We also had sold puts at $27.50, $25, $22, and $20.
One never knows where the stock will go in the short-term, so many of these options ended up expiring in the money, which allowed us to buy more stock at great prices. The combination of strategies tends to give us the risk/reward characteristics that we are looking for as long-term investors in an expensive market. We never know which stock will rise the soonest, but we play the odds and invest the most into our highest conviction ideas. Over time, that has worked out very well for us.
We will try to do more case studies over time on both winners and losers, as I find them to be helpful personally and I hope that you do too. As always, if you need anything or have any questions whatsoever, please don’t hesitate to contact us!