As I explained on Tuesday and last week and last month and ad infinitum, U.S. stocks are in a bubble that has little to do with fundamentals or common sense and everything to do with sentiment, indexing, ETFs, and the triumph of hope over experience. Investors are checking their brains at the door every morning and ignoring the lessons that hammer them time and again that stocks don’t grow to the sky.
Do not be fooled.
I repeat. Stocks are in a bubble. And that means that sooner or later they are going to drop sharply. Saying this won’t make me a lot of friends, but I have plenty of friends. My job is to make sure that the people who read me understand the truth about what is happening in the market. And the truth is that neither the economy nor corporate earnings justify a market trading at anywhere near current valuation levels.
A number of highly respected investors like Seth Klarman, manager of the highly successful Baupost Limited Partnerships, and Jeremy Grantham, whose firm has lost $40 billion in assets due to its negative views over the last year, believe we are in a bubble and prone to big losses in the near future. What you come to learn after investing as long as I have is that investors buy too late what they wish they would have bought when it was a lot cheaper and sell what they are going to need. Right now, fed by the frenzy for passive (i.e., mindless) investing, indexing, and ETFs, they are doing precisely the opposite of what they should be doing.
Right now, investors should be doing two things: Getting out of overvalued, overleveraged stocks and shorting (or buying puts on) them instead. In particular, they should focus on the dying retail sector, and on other closely related sectors that will be dragged down with it – like food service and restaurants.
Kellogg Hasn’t Been “Grrrrreat” for a Long Time (and It’s Getting Worse)
Kellogg Co. (NYSE: K) is a mundane, slow-growing breakfast and snack food company that has been a household name in America for decades. Like its competitors, it is struggling to grow as eating habits change and consumers tire of its unhealthy brands. It keeps rolling out line extensions to try to keep adults interested in its products while relying on new generations of children to consume its products. But in the end, the company’s revenue is stuck in (at best) mid-single-digit growth mode and the company must resort to successive bouts of cost-cutting to maintain margins and profits. While earnings are OK, what’s most interesting is that the balance sheet has been rotting away for years while Wall Street analysts, who wouldn’t know a balance sheet if it were wrapped around their goggle-eyed heads, ignore the company’s deterioration. But according to ETF Daily News, 34 ETFs own the stock, which pretty much says all you need to know about how it can trade at 20x earnings despite growing at a quarter of that rate.
Kellogg has a remarkably weak balance sheet for a company viewed as a stock market stalwart (all figures are as of October 2016). To start with, the company has negative tangible net worth of a whopping $5.06 billion (consisting of $2.2 billion of book value less $4.97 billion of goodwill and $2.3 billion of other intangibles. It also has negative working capital of $1.7 billion (consisting of current assets of $3.3 billion less current liabilities of $5.0 billion). The company matter-of-factly reports that it always runs a large negative capital deficit, but this would be a problem if market conditions or business conditions specific to the company suddenly deteriorated. Naturally, nobody worries about that happening in today’s world, which is precisely why I am worried about it. Well-managed companies do not run large current account deficits regardless of how they try to spin them.
Kellogg is also heavily leveraged with long-term debt of $6.3 billion and another $928 million of pension liabilities. Ignoring its intangible assets and pension obligations, its debt-to-equity ratio is 4:1. Including those items (which are very real), it is coyote ugly (or, in honor of Tony the Tiger, should we say Tiger Ugly?). Like every other company in America, the company keeps buying back its own stock: $426 million over the first nine months of 2016 and $381 million over the similar period in 2016. Management clearly does not give much thought to reducing debt or the health of the balance sheet, but I can promise that during the next recession or financial crisis, it will wish that it had.
Kellogg operates in slow-growth businesses – cereals and snack foods. If you listen to the company and read the Wall Street analysts that parrot the meaningless management consultant-speak nonsense regarding the company’s plans to reinvent these businesses, you would think that Kellogg actually deserves the high market multiple at which it is trading (which is multiples higher than its slow-in-the-mud growth rate). But the reality is that the company is scrambling to cut costs and keep its weak balance sheet afloat.
Its latest announcement came on Feb. 8 when it revealed that it is exiting its direct store delivery snack food delivery network by the end of 2017. Investors naturally focused on the fact that K beat quarterly earnings expectations rather than the fact that the shift from direct delivery to an allegedly more efficient warehouse distribution system will likely lead to a 15% sales decline over the second half of 2017 and similar declines in the first half of 2018, leading to overall 2018 revenue declining by low single digits. And that assumes the company pulls off the shift without any snafus, which is highly unlikely. Not only are there likely to be glitches, but the distribution system is not going to greet the change with open arms. Retailers will now be responsible for doing most of the merchandising work on Kellogg products and absorbing more costs, something they are not going to be happy about.
Kellogg is a small player in the snack category compared to much larger Mondelez International Inc.’s (Nasdaq: MDLZ) Nabisco. Nabisco made a similar attempt to change its distribution system in the 1990s and faced sustained market share pressures as a result. So did Kraft Foods Group Inc. (Nasdaq: KRFT) when it implemented a new merchandising direct store delivery initiative a decade ago and saw a significant drop in sales. History shows that such moves are never pulled off without a hit to sales and earnings, and there is no reason to think that Kellogg will do any better than its predecessors. Further, we can count on MDLZ to jump all over the opportunity to grab market share away from Kellogg during the transition. With Kellogg’s stock and the broad markets both priced for perfection, the chances for an earnings miss of worse are elevated.
I am recommending three actions on Kellogg. First, if you own the stock, sell it. At best, it is dead money. Second, this is a big-cap stock that is fairly easy to borrow, and it is a good short. So you can short it outright without much risk. The odds of it going up are very low. And third, buy some long-dated K puts (about a year out).
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