Retail’s Last Hurrah Against Amazon

Talking Points

  • Online shopping is a $395 billion industry, but it’s only about 8% of total retail sales in the U.S.
  • Amazon is the 800 pound gorilla in online retailing. 20% of U.S. online sales flow through Amazon.
  • Retail’s last hurray against Amazon is figuring out a way to compete on price.


Note: Data last updated as of June 22, 2017.

A record 8,640 stores are closing in 2017.  Retail is dead!  Everyone will shop online.  Those are the news headlines nowadays.  The question is, do the headlines support the data?

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There is a shift towards online shopping.  This secular trend is led by Amazon (AMZN) with visionary leader Jeff Bezos.  Amazon’s customer centric business model is forcing a price war.  It’s hard to compete when Amazon doesn’t care about profits, at least for now.  The obvious winners are customers.  We benefit from lower prices and better shopping experiences.

Behind the headline numbers, the data shows retailing isn’t dying.  It’s actually growing.  What retail is experiencing is a shift in market share.   Customers’ tastes and preferences change with the times.  Before, customers wanted reputable brands and quality customer services.  Many retailers have replicated those desires.  Nowadays, customers want great bargains and unique shopping experiences.

There are retailers who failed to adapt their business models to accommodate customers’ wants and needs.  The numbers show up in their financials.  It’s not just Amazon that’s doing well.  Other retailers are thriving because they have business models focused on finding bargains and experiential shopping.  However, investors are pricing Amazon’s stock as if it’s going to take over the world.  That could be the case.  Retail is a very large industry; it’s about $5 trillion in the United States alone.  With growth comes competition, and Amazon’s growth might give other retailers a fighting chance.

The Retail Landscape

The Bird’s-Eye View

Retail is a large, fragmented, and booming industry.  It’s about $5 trillion in the U.S. alone, and growing.

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Also, retail is a very resilient industry.  Growth only turned negative twice since 1992, mainly due to the Great Recession in 2008.  The U.S. consumer continues to spend even with all the political drama, recessions, wars, and natural disasters.

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There are two factors behind growing retail sales.  The first is higher wages.  The median household income in the U.S. is about $59,000.  It was about $31,000 back in 1992.

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Wages increased about 2-3% annually since 1992, which is about the rate of inflation.

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The second factor is population growth.  The U.S. population was about 322 million in 2016.  It was about 257 million in 1992.

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The U.S. population increased about 0.7 to 0.9% annually since 1992.

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Let’s look at the growth in retail sales.  It’s about 3-4% annually since 1992.  That’s about the sum of higher wages and population growth.

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People say the U.S. is a consumption driven economy.  I agree.  Spending per person is increasing.

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We’re spending more because we’re making more money.  Some may argue with that statement.  I can only say check the data yourself instead of reading about it from a perma-bear who use fear to sell their newsletters.  Today, the average person spends about 29% of their income shopping.  It was about 25% back in 1992.

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The Consumer

The U.S. consumer continues to do well.  Of course, the past isn’t a guarantee of the future.  What’s interesting is consumer spending is shifting.  The average person eats out more nowadays.  The trend shows we’re spending a higher percentage of our income eating out.

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That’s interesting because we’re spending the same amount on groceries still.

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With food so good and food pictures so popular, there’s a good reason to wine and dine more.

Online shopping is taking a bigger share of our wallets.  What’s interesting is online shopping is still a tiny percentage of the average person’s overall spending.  There is definitely more room to increase that overtime.

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We get that the U.S. consumer likes to shop.  Retailing is growing because of higher wages and population growth.  But all this shopping must be putting a strain on consumer finances, right?  The headline says the household debt is too damn high!  It’s going to be 2008 all over again, just you wait!  Well, I’m still waiting.

Total household debt is increasing.  It’s $12.6 trillion as of 2016.

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Of the household debt, mortgages make up the majority.  We all have to live somewhere so that makes sense.

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On a micro level, the total household debt per person peaked in 2008.  The current debt per person is around $39,000, still below the 2008 peak.

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On a debt to income level, the U.S. consumer is average.  The debt ratio peaked in 2008.  Since then, we reverted back to normal levels.

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Looking at the types of debt, we’re spending less on our mortgages.

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Auto loans and credit cards are at normal levels.  Auto loans have been ticking up in the past few years.  It looks like it’s cooling down based on recently sales data.

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What’s interesting is student loan debt.  That’s been trending up.  Everyone thinks they need a college degree to get ahead in life.  When there’s a high demand then prices will increase.  We see college tuition increasing and people taking on debt to fund their education.

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What’s interesting is student loans are higher than auto loans nowadays.  That’s something to think about.  Perhaps the next bubble brewing?

The Rise of Online

Before, a retailer like Nordstrom’s (JWN) could differentiate itself with friendly customer service and easy-going return policies.  With retail, those features were easily replicated and became standard for most retailers.  The internet brought price transparency and product reviews.  This greatly influenced how customers behave and shop

Online shopping started back in 2000, or when data first became available.  The industry is about $395 billion in the U.S.

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You would think online would make up a larger portion of total retail sales, but it’s only about 8% of retail sales, excluding food services and motor vehicles.

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The growth in online sales is growing at a consistent mid-teens rate.  At this rate, online sales can easily make up 20% of all retail sales within 5-7 years.

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Department Stores Dying

Department stores are struggling big time.  However, this has been the case for many years.  This has been a slowly declining segment of retail.

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The business model for most department stores stopped working long time ago.  There are two main reasons.  The first is most department stores have saturated their markets.  Net new stores have been flat or declining for years.  The second is no one wants to pay full price for anything and drive far to do so.  I remember spending time at the mall with my friends after school.  We didn’t have texting, social media, and mobile gaming back then.  This forced us to actually hang out in person.  Weird right?  Technology changed that.

The Rise of Amazon

Amazon has greatly benefitted from the shift to online.  Actually, they were one of few pioneers in online retailing.   Even with Amazon’s amazing growth, it’s still a very small percentage of retail sales.  Heck, Walmart is still bigger than Amazon.

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Amazon is the 800 pound gorilla in online.  20% of U.S. online sales flow through Amazon.  Amazon is growing faster than online retail so it’s taking market share.  I think Amazon is taking market share from retailers too worried about maintaining their fat margins.  Like Jeff Bezos said, “Your margin is my opportunity.”

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How Retail Works

Retail is simple.  The customer wants a product.  Your job is to facilitate the transaction.  Retailers basically connect buyers and sellers; they’re the middleman.  Most retailers don’t create any special products.  Customers only care about being able to buy the product and buying it at the lowest price.  If a customer can buy product A from seller A or B then the customer will most likely go with the seller with the lowest price.

Good retailers stay in business by being the lowest-cost producer.  It’s that simple.  My folks ran a retail store for over 20 years and we competed on that model.  There are 3 things you need in retailing:

  1. Having the lowest prices,
  2. Strong balance sheet,
  3. And good taste.

Good taste means you have products customers want.  You have to be able to predict product trends and ride them.  Then you offer the lowest prices.  There are periods where times are tough so you will need a strong balance sheet to weather the storm.  Back in 2008, a lot of stores closed because they took didn’t reduce inventory fast enough and took on too much debt.  Meanwhile, my family’s store had no debt and we slashed prices to move inventory.  As competition faded then prices stabilized and margins improved.

The business model for retail is simple too.  First you open a store and increase sales to that store, aka increase same-store-sales (SSS).  Then you open a new store.  You keep opening new stores and increasing SSS until the store concept saturates the market.  As the business grows you’re buying more inventory, meaning you’ll probably have leverage over supplies.  You’re basically buying more and paying less.  You pass the savings onto your customers and cut cost by improving distribution and operations.  Overtime, margins will increase because price per unit decreases and your fixed operating costs decreases.  You’re generating a lot of free cash flow and that gets reinvested back to opening new stores and improving existing ones.  Eventually, you’ll pay a small dividend and buy back lots of shares.  The result is the stock price goes up overtime.

Examples of Dying Retailers

Before we look at the good retailers, let’s look at the bad ones.  Bad retailers are struggling because of two reasons:

  1. Their stores saturated the market place,
  2. And they aren’t the lowest-cost producers.

Market saturation means a retailer can no longer open new stores without cannibalizing existing ones.  If they open a new store then existing stores’ SSS would decrease. Examples of bad retailers are:

  • Macy’s (M)
  • J.C. Penney (JCP)
  • Sears (SHLD)
  • The Gap (GPS)
  • L Brands (LB)
  • Kohl’s (KSS)
  • Best Buy (BBY)

Take a look at each bad retailer’s revenue.  Most are flat, declining, or starting their decline.

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If you dig deeper, their net new store openings are barely growing or declining.

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Also, let’s look at their operating margins.  Most are on the decline because they’re being forced to compete on price nowadays.

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The margins look super high when compared to say Walmart (WMT) and Costco (COST).

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When you’re that profitable then you’re just asking for competition.  Most bad retailers’ margins peaked a few years ago and are on the slow decline.

Examples of Good Retailers

Meanwhile, good retailers compete by having the lowest prices and unique shopping experience.  Heck, it’s even in their mission statement.

Examples of mission statements are:

  • Walmart (WMT) – Save Money. Live Better.
  • TJX Companies (TJX) – Deliver Off Price Value
  • Ross Stores (ROST) – Dress for Less.
  • Ollie’s Bargain Outlet (OLLI) – Good Stuff Cheap
  • Dollar General (DG) – Save Time. Save Money. Every day!

We know good retailers operate on the lowest prices.  However, they have plenty of white space to grow in their markets.  Most aren’t event half way to market saturation.

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Also, if you notice most good retailers structure store layouts for unique shopping experiences.  You never know what you’ll find at each store because the products are tailored to that location.  For example, TJX stores play on the treasure hunt experience.  You’re unlikely find the same inventory at each store.  COST switch their inventory often so you don’t know what to expect every time you visit.  Also, people enjoy shopping at COST because of the samples and product demos.

Retail Real Estate Evolving

Real estate is always evolving because peoples’ tastes change.  Giant shopping plaza establishments worked because shopping was a form of entertaining.  Also, going to the store was the most convenient way to make a purchase.  You didn’t need a reason to venture outside to shop because you had to shop.  It was the only option!

Nowadays, newer successful developments incorporate a mixed-used environment.  Basically, developers are building mini eco-systems to make foot traffic flow more naturally.  Before, developments were segregated, meaning one district was built for shopping while another was built for housing or offices.  Nowadays, everything is merging, especially in the suburban areas.  Urban areas such as New York City and San Francisco already had mixed-used real estate given the location density.  You had to build vertically because space was limited horizontally.  In the suburbs, that’s not the case.  You can build horizontally for a while before you run out of space.  The problem with that is if you build a shopping plaza in the middle with housing surround it then going shopping becomes a chore.

New developments such as Tyson’s Corner and the Mosaic District in the Washington D.C. area are great examples of mixed-used real estate assets.  Apartments are built on top of retail and restaurants.  Offices are located throughout the district.  This means foot traffic is more naturally flowing during all times of the day.  Retailers and restaurants benefit because there is consistent and predictable foot traffic.

Here are some renders of Tyson’s Corner.  You can see retail, office, housing, and entertainment being mixed in this real estate asset.

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Another example is the Mosaic District.  The movie theater and Target are the main anchors.  Apartment buildings and offices surround the district create consistent foot traffic.

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Another prime example of mixed-used is Howard Hughes’s South Street Seaport development in New York City.  Disclosure, I own Howard Hughes (HHC) and am bullish on its future.  Back in May 2017, I toured the South Street Seaport during the company’s investor day and came away optimistic.

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What HHC is doing with the South Street Seaport is really unique in terms of retailing, dining, and entertainment.  Most shopping venues are just glorified showrooms for big brands like Coach, Victoria’s Secret, The Gap, and etc.  Every mall has the same retailers basically.  With the retailers at the Seaport, it’s their only location in NYC, or even the state and country.  Visiting the seaport will be truly a unique shopping experience.  Also, events are always held at the seaport.  They’re planning a summer concert series and a winter ice rink.  The location is irreplaceable.  Imagine all the selfies you can take and brag to your friends about on Instagram.

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There are a lot of exciting things happening in retail and real estate.  Most are in their early developments, but hopefully it’ll be the normal in the near future.

Winner Takes All?

How Long Will It Take for Online be Dominate?

Let’s get back to Amazon.  Currently, online shopping makes up about 8% of total retail sales.  It’s growing at a nice 15% annually.  Online shopping will gain market share because it’s growing faster than the overall retail industry.  Looking out 5 years, online shopping could make up more than 15% of total retail sales.

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Looking out 10 years, online shopping could make up more 30% of total retail sales.

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Amazon is growing faster than both overall retail and online retail.  However, Amazon’s retail sales are mostly online, which makes its growth limited to the online retailing segment.

Overall, there is still a long runway before majority of sales are performed online.  In the end, I think it’ll be evenly split like groceries and eating out.  I doubt everyone would buy solely from online.  You cook at home, but still go out to eat.  One way traditional retailers can combat that is through experiential retailing.  It incentivizes people to venture outside and actually enjoy the outdoors.

Amazon’s Market Opportunity

Amazon is growing, and it’s growing fast.  However, Walmart is still bigger than Amazon.  If Amazon continues to grow at 25% annually while Walmart grows at 2%, then Amazon will overtake Walmart within 7 years to become the dominate retailer in the U.S.

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Online sales segment was recently broken out by the U.S. government.  It’s interesting to note the different segments.

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The electronics & appliances category shows the highest e-commerce penetration of any retail category, with nearly 20% of total online sales in 2015.  Meanwhile, food & beverage stores, which consist primarily of groceries and supermarkets, remain among the lowest for online share at 0.1% and only $1 billion in total online sales.  This could change.  People could be more comfortable with buying everything online.

The benefit Amazon had was being the first mover.  Online shopping wasn’t a large and highly unprofitable industry.  That is changing.  As the online shopping segment grows, retailers are figuring out ways to make a decent profit.

What will happen?  I think pricing will play a big factor.  You can easily shop multiple places to find the best deals.  For example, Walmart is becoming very competitive with their online offerings.  Walmart’s online sales is still a tiny fraction, but it’s growing faster than Amazon.

Also, most retailers are subsidizing shipping if your order exceeds a certain order amount.  Free shipping is becoming the standard nowadays, along with a friendly return policy.  Another factor is transaction barriers.  Before, you would have to create an account with that retailer’s website before entering your credit card, and then make the purchase.  That’s slowly changing.  Transaction barriers are being lower by just entering a credit card or using a third-party payer such as PayPal.  Eventually, Apple Pay or Google Wallet might be the default payment option for most purchases.  I’m noticing this when making a purchase thought apps on my phone.  Apple Pay shows up and I just pay.  No credit card needs to be enter for each app.

Whole Foods Case Study

One example of first mover advantage and a slow decline from grace is Whole Foods (WFM).  They pioneered and dominated the organic segment.  Organics was a fairly niche market.  Customers were willing to pay a premium because they couldn’t get products elsewhere.  They would spend their “Whole Paycheck” to eat healthy.  Other grocery retailers weren’t interested in organics because it was a tiny market share with low profitability.  However, the organics segment grew rapidly.   Competition entered and prices came down.  Eating organics is becoming affordable.

Before, investors thought prices didn’t matter because Whole Foods provided a unique shopping experience.  Customers would pay a premium to shop at Whole Foods.  The dining and shopping experiences were so unique that customers would pay a premium just to shop there.  Well not everyone is going to pay a premium for the same product.  Fast forward, Whole Foods is now force to compete on price.  Competition caught up and drove down prices.

Just look at Whole Foods margins compared to say a Kroger (KR) and Costco (COST).  Whole Foods’ margins were super high.  That isn’t going to last forever.

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Amazon recently acquired Whole Foods.  The margin question still comes into play.  To expand Whole Foods’ market share, prices will have to come down, which means lower margins.  Of course, Amazon can try to automate the cashiering and distribution processes, but so will competitors.  In retail, many features are easily replicated overtime.  For example, Costco is known for their samples.  Other grocery stores have samples now.  TJX’s treasuring hunt shopping is being replicated.  I think the same will go for Amazon’s Prime Shipping.  We’re seeing 2 day shipping being replicated as well.

In the end, a retailer is still the middleman.  This is the concern I have with Amazon.  As competition picks up, Amazon will be force to constantly compete on price.

Amazon Priced to Perfection

Amazon is priced to take over the world.  A lot of things have to go right for investors to receive a good return in Amazon’s stock.  If the growth slows then there goes the high multiple awarded to the stock.

If we look at Amazon’s valuation, it’s always traded at high multiples.  Currently, the stock trades above its historical averages.  To give you some context, most retailers trade at 1.0x or less Price-to-Sales (P/S).  A high P/S ratio indicates high margins and growth.  In Amazon’s case, they’re rewarded for having high growth with low margins.  Of course, investors are betting that Amazon will have above margins in the future.

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Amazon’s P/E is much higher.  It’s currently at 190 times.  I think using historical P/E is irrelevant in Amazon’s case given how volatile margins are.  There is no consistency, thus making it difficult to value based on earnings.  At some point, investors are betting margins will stabilize and Amazon will be valued accordingly.

Bull Case

Amazon is a fast grower, putting up 25% annual revenue growth in the past years.  Let’s assume this trend continues.  We’ll forecast out 5 years.  It’s hard to predict what I’m eating for dinner so looking out say 10 years is really difficult, for me anyways.

Net Sales are currently $142.6 billion.  We assume no share dilution, even though there is.

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Also, we’ll assume an exit P/E ratio of 30 on future earnings per share.  The S&P 500 average multiple is 16-17 times.  The exit P/E is almost double.  I think that’s generous.

The final question is Amazon’s future earnings.  Amazon separates earnings into 3 types.

The first is free cash flow. It’s defined as free cash flow is cash flow from operations reduced by “Purchases of property and equipment, including internal-use software and website development, net,” which is included in cash flow from investing activities.

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The second is Free Cash Flow Less Lease Principal Repayments.  It’s defined as free cash flow less lease principal repayments is free cash flow reduced by “Principal repayments of capital lease obligations,” and “Principal repayments of finance lease obligations,” which are included in cash flow from financing activities.

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The third is Free Cash Flow Less Finance Lease Principal Repayments and Assets Acquired Under Capital Leases.  It’s defined as Free cash flow less finance lease principal repayments and assets acquired under capital leases is free cash flow reduced by “Principal repayments of finance lease obligations,” which is included in cash flow from financing activities, and property and equipment acquired under capital leases. In this measure, property and equipment acquired under capital leases is reflected as if these assets had been purchased with cash, which is not the case as these assets have been leased.

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Below are different margins that Amazon currently has depending on the types of free cash flow.

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To give some context, Walmart operates at about 3% net margins.  Costco operates at about 1-2%.  KR operates at about 1-2%.

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Of course, you have Amazon Web Services, which is supposed to be higher margins.  I think pricing will ultimately determine customers’ buying decisions, which means lower margins.

We’re still bullish here so let’s assume net margins increase to 10.0%.  Our assumptions forecast Amazon’s stock price to be about $2,696 in 5 years.

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The upside looks very attractive.  You’re getting around 22% annually if buying Amazon’s stock today.

Bear Case

The bear case is competition catches up and growth slows down to 15% annually.  Also, margins are on the lower end at 5%, still high for a retailer.  The exit multiple is lowered to 20 times.  This gives us a stock price of about $590.

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The stock price declines significantly because of multiple contraction.  There is a lot of downsize in the bear case because the Amazon thesis is betting on high growth and margin expansion.

Base Case

Let’s look somewhere in-between.  Revenue growth holds steady at 20% annually.  Net margins are stabilize at 7%.  The exit P/E multiple is 25x.  That sounds pretty reasonable.  This gives us a stock price of $1,278.  There is upside in the Base Case; it’s better than treasury rates.

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Amazon is considered a growth stock.  If the growth continues then Amazon’s stock will go up.  Based on the valuation scenarios previously, investors are expecting Amazon to do amazing things.  Only time will tell if Amazon can live up to these high expectations.


Retail is a tough business.  Congrats to Amazon for delivering tremendous value to customers and shareholders.  Amazon made it easier for us to buy more things we may never need, and that delights us.  However, I can’t see a world where only a handful of companies rule the world.  Capitalism incentives innovation and disruption.  There will always be competition lurking around the corner wherever the profits lie.

Retail’s last hurray against Amazon is figuring out a way to compete on price.  In the end, retail is about being the lowest cost producer.  Customers are willing to shop wherever they can find a good bargain.  As Steve Tanger says, “In good times, people love a bargain, in bad times people need a bargain.”

With that said, there might be some hope for retail.  I saw this signed at my local Sears recently.  They’re hiring!  *sarcasm*

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A Tale about Market Valuations

Talking Points

  • We would see a 25% decline in the S&P 500 if the P/E ratio contracts from 22.0 to 16.5.
  • 3 sectors had negative EPS growth in the past 3 years: Energy, Materials, and Telecommunication Services.
  • The consensus 2017 EPS estimate is 128.52 per share, a 21.0% increase from 2016 EPS in the S&P 500.


Note: Data last updated as of June 8, 2017.

Once upon a time, there was a bull and a bear.  Both had conflicting viewpoints.

The Bull saw greener pastures.  He even wrote a book titled Stocks for the Long Run.  The premise was simple; stocks delivered the best total returns of any asset class over the long-term.  His outlook remains positive for stocks with solid returns for the long run.

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Meanwhile, the Bear thought the greener pastures were fertilized with bullshit.  His book, Irrational Exuberance, says what goes up must eventually come tumbling down because business is cyclical.  The S&P 500 has been trending up since 2009, reaching new highs, and turning bears into bulls.  This above average performance must eventually revert back to average says the Bear.

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With the stakes so high, who will prevail in this raging battle between Bull versus Bear?

By the Numbers

The Bullish Stats

In the green corner, we have the Bull.  He’s optimistic because historical data shows positive and consistent trends.

Let’s look at the S&P 500 closing price from 1960 to 2016.  It started from 58.11 and climbed to 2,238.83, a nice 6.7% compound annual growth rate (CAGR) during that time period.

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Also, the returns remained consistent across different rolling time periods.

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Since the Great Recession in 2008, stocks have done even better than the historic 6.7% CAGR.  However, investors shouldn’t expect double-digit returns going forward.  Still, 6-7% CAGR is good long-term!  That’s average, and apparently being average is amazing nowadays.

What about dividends?  It gets better.  If you would’ve reinvested the dividends from 1960 to 2016 then the closing price on the S&P 500 would’ve skyrocketed to 12,131.20, or 9.9% CAGR. 

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Again, the returns remained consistent across multiple time periods.

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The dividends added an extra 2-3% onto the S&P 500’s returns.  That’s a huge difference over the long-term.  I can see why investors are hyped about the dividend growth strategy!

The Bearish Stats

In the red corner, the Bear thinks today’s investment environment is abnormal.  We operate in a historically low interest rate environment.  Valuations are above their historical averages.  This doesn’t seem normal at all.  I hear from folks that this is the most hated bull market in history.  Eventually, valuations will revert back to normal.  The problem is we don’t know when.

Currently, the S&P 500 trades around 22.0 times earnings.  The historical average P/E ratio is between 16-17 times.  Across different rolling time periods, the P/E ratio averages have been consistent, with a trend of higher P/E ratios in recent rolling years.

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If tomorrow, the P/E ratio contracts from 22.0 to 16.5 then we would see a 25% decline in the S&P 500.  People freak out if stocks are down 1%, just imagine if we get drop over 10.0%!  CNBC would run Markets in Turmoil specials 24/7 and have Dr. Doom and Gloom as the host.

The P/E ratio is even higher if you look at the Shiller PE Ratio.  It’s around 30 times.  The historical average Shiller P/E is between 16-17 times as well.

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You would see a 45.0% decline if we revert back to the average.  That’s a scary thought.  Then again, I don’t think the Shiller PE Ratio is a good valuation metric for the S&P 500.  The disagreement is because taking the average of an increasing value, EPS in case, would make the ratio inflated.  That’s why the trailing-twelve-month PE ratio is lower than the Shiller PE Ratio.  EPS has been growing faster than inflation.  10 years from now, EPS will likely be higher than today.  That’s a discussion for another day.

More Data to Digest

The S&P 500’s returns aren’t generate out of thin air.  Returns are powered by EPS growth.  This trend has been a positive for the Bull.

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Take at a look at the EPS growth over various rolling time periods.  From 1960 to 2016, EPS grew 6.5% CAGR, which closely mirrors the 6.7% CAGR of the S&P 500, excluding reinvested dividends.

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EPS growth has been robust for the past 15 and 20 years.  Excluding P/E multiple expanding and contracting, EPS growth mirrored S&P 500’s returns pretty closely.

The Bear argues that EPS growth in the past 5-10 years does not justify the current valuations.  EPS grew 1.9% CAGR in the past 10 years.  We had the Great Recession during that time frame.  However, EPS grew a healthy 10.0% CAGR since 2008.  It’s only in the past 3-5 years that EPS growth is slowing down again.

There’s a good explanation for the EPS growth slowing down, and even turning negative!

Here is a breakdown the EPS of the sectors in the S&P 500.  3 sectors had negative EPS growth in the past 3 years: Energy, Materials, and Telecommunication Services.

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The obvious standout is Energy.  Oil and natural gas prices just plummeted.  It’s hard to make money when prices are down more than 50%.

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Luckily, there is light at the end of the tunnel for Energy.  Analysts forecast EPS will turn positive for 2017 and 2018, which will contribute to robust EPS growth for the S&P 500.

For what it’s worth, I think Energy earnings will remain depressed going forward.  The world isn’t constant; it’s changing rapidly and new innovations are changing how businesses operate.  Before, the world ran on fossil fuels and industrial production.  Going forward, the trend shows we’re shifting to more renewable energy and service orientated offerings.  Commodity prices can stabilize and Energy earnings can be positive again.  It’s difficult to see +$100.00 oil again unless there’s a huge supply disruption.

Another interesting observation is negative EPS growth.  It has happened in the past.  I counted 12 times EPS growth went negative since 1960.  Over 56 years, that’s about 20% of the time.

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Coincidently, the S&P 500’s total returns went negative 12 times too.

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My takeaway from analyzing the EPS trend is EPS growth is pretty consistent over the long-term.  Yes, there will be setbacks because of recessions and whatnots.  Those appear to be temporary.  At most, EPS growth turned negative for 2 years straight and turned positive again.

For those who are hoping for a bear market, the past shows it’s temporary.  Of course, past performance is not a guarantee of future returns.

The Trend is Your Friend

Warren Buffett said interest rates act has a gravity on valuations.  If interest rates are low then multiples will be higher, and vice versa.

Let’s compare the S&P 500’s earnings yield to the 10-year treasury.

The 10-year treasury peaked at 14.6% in 1981.  The yield has been trending downward since then.  We now operate at historically low interest rates.

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Here are the average earnings and 10-year treasury yields over various rolling time periods.  Both yields are trending downwards.  The 10-year treasury average 6.2% since 1960 and is now 2.2%.  The S&P 500’s earnings yield average 6.8% over the same time frame and is now 4.6%.

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What’s interesting is the spread between the earnings and 10-year treasury yields is widening in recent years.  We can see a few different scenarios can play out.  The first is the spread narrows.  This requires either bond yields increasing or stock multiples going up.  The other scenario is the spread widens.  This requires either bond yields declining or stock multiples coming down.

Looking Into the Future

With all of that said, what really matters are future returns.  The billion dollar question is “Will the S&P 500 go up or down from here?

Bull Case

Analysts are quite optimistic about the future.  The consensus EPS estimate for 2017 is 128.52 per share.  That’s a 21.0% increase from 2016 EPS!  2018 consensus estimate is 145.80, or 11.9% higher than 2017 EPS.

Let’s assume the estimates are accurate.  Analysts are really good at their jobs and predicted the future accurately.  It would definitely make my job easier.  If we assume the P/E ratio contracts from 22 to 20 then the S&P 500 closing price for 2017 and 2018 will be 2,570.40 and 2,916.00, respectively.

With dividends, we can expect an upside of 7.5% and 22.0% returns for 2017 and 2018, respectively.  That’s not too bad.

Also, it’s interesting to note future valuations in the bull case.  If the EPS estimates are accurate then the S&P 500’s forward P/E looks actually reasonable.  Valuation revert back to normal if the S&P 500 remains flat going forward.

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Bear Case

Now, let’s assume analysts are human like the rest of us and their estimates are wrong.  It’s okay, we all make mistakes.  Double-digit EPS growth for the next 2 years sounds pretty optimistic, especially in the later stages of the business cycle.  We’ll say EPS growth will average 6.5% for 2017 and 2018, which is the historical average EPS growth.  The multiple will revert back to average to 17.0.

With dividends, the down size is -19.2% and -14.0% returns for 2017 and 2018, respectively.  Ouch, that doesn’t look too good.

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In the exercise above, the bull case is we get above average returns if the estimates hold up.  There are good catalysts in the near-time to generate strong EPS growth. We have the Energy sector possibly rebounding, tax reforms, clarity on health care reform, new infrastructure spending, low unemployment, and increasing wages.  All of this can contribute to healthy EPS growth.

However, the bear case is we lose money.  If most of the catalysts don’t happen then valuations can begin to revert back to normal.

Base Case

Those viewpoints are on opposite ends of the spectrum.  If we look somewhere in the middle then things look meh.  Let’s say EPS growth reverts back to normal to 6.5% CAGR.  However, interest rates remain low so the P/E ratio stays elevated at 20 times.  Then future returns would be below average going forward.

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There are 3 possible scenarios: we make money; we lose money; or we break even.  This little exercise shows that investing is difficult, especially at the macro level!  It’s all about probabilities and there are a lot of scenarios that can happen. 


Who won the battle of the Bull versus the Bear?  And the winner is… I’d say it’s a draw.  There are too many external factors to consider.

For now, markets are above their historical averages.  In the United States, the low-hanging fruits have been picked and it’s harder to find opportunities nowadays.  However, I run a pretty concentrated portfolio and make a few investments per year.  There’s no excuse not to find a few ideas to invest in.  I just have to flip over more rocks and kiss more frogs.

The investing game isn’t supposed to be easy as Charlie Munger would say.  As investors, sometimes we just have to play the game on hard mode and refine our skill sets.