Christmas is coming, and that means two sets of flurries are on the horizon – snow and retail news. Now that the aftershocks of the 2008 financial collapse have had time to set in, this year will be a test to see how resilient consumers are in spending for the holidays. Retailers, for their part, have been preparing by slimming down; most are carrying record low levels of inventories to avoid the need for post-rush markdowns. But as the fundamentals are uncertain, retail stocks have been rallying with the rest of the market – the Retail HOLDRs ETF (RTH) is less than 13% off its all-time high in July 2007, led by large allocations to Wal-Mart (WMT), Home Depot (HD), Target (TGT), and Walgreen’s (WAG).

Large-cap, diversified retailers lack the appeal of a growing niche apparel company, for instance, but in many cases they look to be safer bets with decent upside in a market that’s looking increasingly overextended. Wal-Mart and Home Depot attract my attention with relatively stronger moats for the retail industry and a consistent history of posting ROEs in the double-digits, and although they trade at higher earnings multiples than a company like GameStop (GME), I believe the sustainability of earnings favors the stodgier retailers. Earlier this year, investment funds that I co-manage (BCIC) sold GameStop stock on a belief that it is a value trap with illusory single-digit forward earnings multiples, as competition for video game sales increases, and video game makers look to connect directly with consumers and disintermediate brick-and-mortar stores. That stock is down 15% in the last week and is close to its 52-week low, one of the exceptions in a market that is making new 52-week highs.

There will be plenty of news on short-term sales trends involving consumer spending in the month of December, but there might be limited comparability with past years because the paradigm may have shifted in this newly frugal economy. If you’re going to play with retail stocks, then, stay high quality and go with solidly entrenched middlemen. Bed Bath & Beyond (BBBY) is one retailer more off the beaten path that also fits that definition – a differentiated inventory strategy, improved pricing power after the Linens ‘n Things bankruptcy, and a modest valuation – and I’m happy BCIC owns it.
On the apparel front, Goldman Sachs (GS) analysts believe the sweater will be the go-to gift of 2009; while apparel is admittedly not my specialty, BCIC recently established a position in Ralph Lauren (RL).

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Originally posted here.

I have not posted in a long time, having been busy interviewing for post-graduation jobs, but I just received an email from Forbes asking a question that was eerily relevant to the situation many of my peers find themselves in – it read,

“Recently, the U.S. Bureau of Labor Statistics reported a jump in the unemployment rate to 10.2%. Some economists think we could be looking at 10.5% by early next year. Given these grim forecasts, how do you counsel recent college graduates and others entering the job market for the first time in this employment climate? Is there any advice or strategies you find particularly useful?”

After interviewing for a number of finance jobs, I wound up with several offers, including two doing equity research at large buy-side firms – exactly the position I wanted. Forgiving the somewhat cliched headings (I hope the descriptions make up for it), I found the following things beneficial, and hope they can be used in your personal situation:

Know what you want
It sounds trite, but the number of students who don’t have a good idea of what they’d like to do after college is surprisingly high. If you don’t know what you want to do, why should an employer hire you?

In my case, I identified investment management as a dynamic, intellectually challenging field that would hold my attention and challenge my analytical abilities early on. Do some introspection and examine what skills you have, then figure out where they’ll be put to good use in an enjoyable way. There’s no substitute for putting in the time to think.

Show your passion
Once you’ve identified what you want to do, capture it on your résumé by involving yourself in a relevant activity. If you actually want to be in a certain line of work, this won’t be a huge imposition. Should a readily apparent method of accomplishing this not be handy – there might not be a club at your school, or a field/service trip, a study program, etc. – then get on the internet. Find people doing what you want to do, and contact them. If everything comes up empty, start a website– it doesn’t have to be a grand production, just steady documentation that you’re trying to learn about something.

I started my website because I was bored during exam week freshman year. Through it, I’ve been read by tens of thousands of people, invited to write for much larger publications, and had opportunities to meet and talk with dozens of incredibly helpful people in the finance industry.

Put in the time
As the first point said, there’s no substitute for actually investing the time positioning yourself to get hired. The word choice is intentional; learning about what you want to do really is an investment in your future. A willingness to study countless hours for classes in tangential (at best) subject areas while spending no time planning a destination after college is simply short-sightedness and poor strategy. Whatever is fundamental to the job you want to be hired in, you should be actively learning right now.

I’ll often be talking to other students who want to enter finance, and they’ll ask what books I read to get to the level of knowledge they think I have. Though I don’t give this answer, I conservatively estimate that I’ve spent more than 6,000 hours reading anything and everything about investing, financial markets, etc. that I’ve come across. That translates to 3 full years of 40 hour weeks, and I think that is on the low side.

Is that time commitment necessary for everyone? It’s just something that I did – and it does have its drawbacks beyond the obvious skipping of college bar happy hours. At least two jobs I interviewed for didn’t extend me offers because they felt my level of background knowledge would have made me a poor fit for their entry level program. I’m encouraged by that long-term, however, because it should help me at places which are more flexible and offer greater responsibility sooner.

Go deeper in certain areas
Knowing what you’re interviewing for is too broad a suggestion and should be a given. To stand out in an interview pool against similar students who have similar course work, dig deeper into a few specific niches in the field you’re interviewing in, so that you know them better than anyone else your interviewer will see that day. My areas were railroad business models and valuations (I was lucky that Mr. Buffett made his acquisition when he did, my thanks to him), as well as credit default swaps – esoteric, yes, but very effective because I know them well.

Having familiarized myself with countless companies over the past several years, it was also much easier to discuss General Electric (GE), Freeport McMoRan (FCX), supermarkets, agriculture, pharmaceuticals, and certain retailers, depending on the sector background of the person interviewing me. All of those made appearances, and I happen to have done research into each of them previously.

Create and sell a narrative
In the end, a résumé is piece of paper with data points. The goal of an interview is to turn those data points into a story that’s easy to remember because it’s so compelling. On paper, I’m a finance major with a good-but-not-great cumulative GPA who is also the vice president of my school’s investment club. In an interview, I can talk about major market events that occurred pre-housing bubble, display an odd fascination with poorly-performing small-cap railroads, and can relate my involvement with investment club to at least one stock in the universe of the person interviewing me. That turns the relatively boring data point of “extensive investing study” into something worth remembering – everything on your résumé should come with a catchy, memorable story mentally attached.

Since I’ve probably taken away valuable time that can be used to start with #1, I’ll conclude by saying that there’s no substitute for working hard, that the time invested is worth it, and that jobs are not impossible to come by if you’re willing to set yourself apart by prudently picking a direction and then following it with everything you have.

A final note – writing this made me reflect on the journey. Thanks, Mom and Dad, for humoring my odd interest from a young age, caring so damn much that I do well, and putting your wants behind an education that couldn’t have been easy to afford.

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After Buffett’s investments in a handful of major railroads – Union Pacific (UNP), Norfolk Southern (NSC), and most notably Burlington Northern Santa Fe (BNI) – the industry garnered plenty of attention. The attractive industry dynamics and a myopic focus on the major players makes me interested in the small number of publicly traded regional railroads – among them Kansas City Southern (KSU) and Genesee & Wyoming (GWR).

Why railroads? Foremost, it’s an industry with significant tangible barriers to entry, and it provides a vital economic service. Although fixed asset investment is substantial, I also believe that the general consensus underestimates the variability of the typical railroad’s cost structure – yes, there’s operating leverage there, but there is also room to reduce headcount as unit volumes decline. Below is a graph of quarter-over-quarter revenue growth compared to QoQ operating expense growth for two major carriers (Norfolk Southern and CSX), one larger regional (Kansas City Southern) and the short-line amalgamation G&W.

A fixed asset business is going to have scale, but there’s still a fair degree of correlation for those companies. For the quarterly dataset going back to the beginning of 2006, the slopes vary from 0.51 (NSC) to 0.87 (GWR), so some flexibility exists in aligning expenses with revenues.

Next is a list of several metrics used to compare the four railroads, focusing primarily on their track infrastructure. Although other equipment is needed to operate a railroad, the real economic asset I’d be buying is the network.

A few explanations: there’s a strong correlation between revenue per track mile to market value per track mile. I chose to use enterprise value in addition to market cap, since these rails all have some level of debt attached and the end results cluster around 2.5x revenue per track mile. Also, the capital spending necessary to maintain the track network is important, and for the larger and more continuous players, spending is substantially higher than for a fragmented short-line company like G&W.

One red flag that makes me tread with caution is that railroad stocks have generally seen a robust recovery since the March lows, though I’m wary of mentally anchoring to those prices. On the whole, the rail industry has several positives about it – so even if a cross-section of some stocks don’t show any great bargains, it’s an understandable industry with competitive advantages, and that means good returns can be obtained at the right price.

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In a note to file under the “Playing for Time” theme, the Curious Capitalist notes:

First American CoreLogic has taken a look at the effect of the government’s efforts to drive down mortgage interest rates, which, among other things, makes for easier refinancing. According to the loan analytics company, in the first half of 2009, refinancing homeowners set themselves up to save some $11.5 billion over the next five years. The typical person who refinanced was able to drop his monthly payment by $120 a month, a reduction of 10.5%… The value of mortgage originations hit $664 billion in the second quarter, and 69% of that was refinancing (by contrast, 37% of origination activity was made up of refis in the last quarter of 2o08). Fair or not, the government’s plan at least worked.

Reconcile this with one of the headlines on the site of Connecticut’s new candidate for U.S. Senate, Peter Schiff, which reads, “What America has succeeded in creating is not an economy impervious to shocks, but merely one which enables their consequences to be postponed to a later date.” I’ve spoken briefly with Peter before, and I’ve read his books, but I’m by no means in complete agreement with his views - yet in this instance, what he says is a perfect application to what the banking system is doing with the blessing of our government. Their strategy? Between the PPIP and mortgages, let’s sell as many options as we can now, book a benefit, and hope the adverse scenario that results in our option position(s) taking losses doesn’t occur.

I’ve wondered before whether or not we can carry trade the U.S. consumer back to health by attempting to force Treasury rates and other borrowing rates to converge; I’m not sure, but we’re certainly giving it the old college try.

If the typical person refinancing can save an extra $120/month, where does the money come from? It’s money that mortgage lenders aren’t making anymore in a lower interest rate environment. Now, the yield curve is steep, and short rates are near zero, so the relative change in rates is still helping banks. But at the same time, we’re more heavily leveraging banks to low rates; net interest margins might be getting fat at present, but they will compress and then some when rates inevitably rise. Zero, as James Grant has said, is the wrong rate for any economy, but more and more, I’m leaning toward believing that short rates stay extraordinarily low because of the idea that the economy depends on it - even when reality is that it aids speculators much more than the economy as a whole.

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I haven’t said much about what I’ve been doing personally here of late. In sum, the general theme is that I’ve been scaling out of positions the entire summer, and am now 100% cash. Had I not sold anything, I would be up more on the year than I am at present – but that’s pretty much par for the course in a rally that has been as sharp and persistent as this one.

There’s still a strong undercurrent of disbelief at this rally, so in that sense not much has changed since March, when the world was bearish and nothing but pain existed for equity holders. The difference now (besides much higher prices) is that there’s a growing contingent with a belief that the recovery is at hand, or their more speculative counterparts who don’t believe in a recovery but are afraid of missing a higher move.

A growing number of financial stocks that are essentially worthless have seen their option values multiply several-fold; the well-documented list includes Fannie Mae (FNM), Freddie Mac (FRE), AIG, Citigroup (C), and Lehman (LEHMQ.PK), and August trading volume has been heavily concentrated in those names. I’m not discounting the option value of a stock; real-world outcomes are probabilistic and stock prices should reflect that. But it does speak to speculation returning to the market, and that’s a sign of caution in a time of great uncertainty – and make no mistake, the short-term bandages are only hiding long-term problems.

Good investing is not about having a myopic focus on maximizing returns, it’s also about managing risk. Winning is important, but so is not losing. With the feedback loop of the last six months, market conditions are such that it’s very easy to forget that losing is a distinct possibility in an era of debt deflation. Although inflation has been the headline worry of Fed watchers, I’m not convinced; the intermediate concern (2-5 years) that seems underestimated is deflation. Central banks are small in comparison to global capital flows, and although we might try to stimulate like crazy, it will be difficult to offset trillions of dollars in irresponsible lending being rationalized.

In light of this, I’m looking at convertible securities that offer yields of 6% or more (about 500 bps over 2-year Treasuries) in industries that will have above-average profitability in the case of an economic recovery. My assumption is that the yield alone will offer an attractive return, and with most at a discount to par, the total return potential approaches double-digits over a two-year time frame. If I’m wrong about the immediacy of a market recovery, the convertible option offers a hedge on rising stock prices – in sum, a better balance of risk and reward than either a straight stock or bond allocation.

A final closing note: I’m going to change up my policy about writing, since I often spend dozens of hours studying something only to determine it is a dead end. So, in the future, I’ll comment on those, instead of just the scarce opportunities I end up acting on.

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