No. of Recommendations: 17
2017 was (another) great year for the stock market, and I still need to do some reflection on what I learned and where I need to improve as an investor. One theme I've thought about this morning is the Age of Amazon and how retailers and restaurants have faced their fair share of struggles.

Amazon's acquisition of Whole Foods in June 2017 did a number to grocers and many retailers, driving valuation multiples for many retailers to the lowest levels we've seen since the Great Recession. Tractor Supply Company's P/E multiple hit roughly 15 in July, the lowest valuation for the stock since 2010. Autozone's P/E hit approximately 11.5 in July, the lowest its valuation had been since October 2009.

Autozone was also facing a barrage of fear around how the company would fare if/when electric vehicles (which have fewer parts compared to vehicles with internal combustion engines) become more prominent in the world. Peak pessimism. (By the way, I think those fears are legitimate and worth considering, but I have my doubts that we'll see mass-adoption of electric cars within the next five years... ideally leaving time for Autozone to find a way to capitalize on the transition to electric, similar to how it took advantage of the transition to hybrid vehicles.)

Since July, Autozone is up more than 41% (trading for a P/E of 15.9) and Tractor Supply is up more than 46% (for a P/E of 22.2).

Restaurants have also faced persistent traffic declines over the past two years, in what some are calling a "restaurant recession." There is a strong case to be made that both retail and restaurant space in the U.S. is overbuilt, essentially leading to excess supply and increased competition for the same amount of consumer dollars. This leads to shorter-term pressures for many retailers and restaurants, but I'm increasingly agreeing with Tom E (TMF1000) that the companies with proven records, strong cash flow production, and healthy balance sheets have the capacity to ride out these storms -- and eventually come out ahead when smaller or weaker retailers/restaurants with less cash and more debt eventually succumb to the ultra-competitive environment and close up shop.

One example of restaurant pessimism that caught my eye this year was Cheesecake Factory. After years of steady comps growth, the company finally succumbed to the weak restaurant environment and management guided for comps to decline about halfway through 2017. Not surprisingly, the stock started to tumble and eventually hit a P/E of roughly 13.75 in September 2017, the lowest it had been since 2009.

I started building up a position in the company when the P/E was at 18.7, which was close to a 5-year low at the time. I appreciated Cheesecake Factory's ability to open new stores out of its own cash flow (not relying on debt) as well as its strong long-term operating record and prospects for ongoing store openings. Sure, it's disappointing to see the company's streak of comps growth broken, but it struck me largely as dealing with macro issues rather than company-specific problems.

In cases like Tractor Supply and Cheesecake Factory, I have noticed that I usually do jump the gun and start building positions a bit early before peak pessimism really kicks in. The valuation multiple can always drift lower, particularly when an industry is dealing with persistent macro fears. Even so, this year has proven to me that even if you are early building up positions in companies in this sort of environment, building out positions in stages (as the valuation drifts lower despite the underlying business remaining intact and/or growing) can be rewarding provided you can practice patience.

Cheesecake Factory is up more than 23% since that point in September 2017, and currently trades at a P/E of 17.7. (I realize I'm cherry-picking the start and end points throughout this post, but think they do provide interesting examples.)

I'm rambling at this point, so clearly have some more thinking to do. But I think there is a case to be made that you can benefit if: 1) you are patient, 2) find proven businesses with long-term track records that are struggling due to macro (not company-specific) issues, 3) and start building positions in those companies as pessimism grows and the valuation drifts to multi-year lows.

In the year ahead, I've got one restaurant and one retailer I'm watching closely along these lines of thinking. First is Papa John's, currently trading for a P/E of 19.35 -- which is the lowest it's been since the end of 2012. The company is dealing with some of its own issues (blaming the NFL for its weak sales, etc.) but I suspect the tough restaurant environment has contributed to its slower-than-expected -- albeit still growing (more than can be said for most restaurants right now) -- performance. The valuation multiple can certainly drift lower from here, and I do have some issues with the company bringing on more debt to buy back stock, but I think over the next 3+ years the stock could be a market beater from these beaten-down levels. Will be one to watch.

A retailer I'm watching through this lens is Ulta Beauty. This is a best-in-breed retailer putting up near-perfect numbers across the board as far as retailers are concerned, but the company hasn't been immune to worries about potential competition from Amazon as well as increased pricing competition from desperate department stores. The stock bottomed out at a P/E of less than 25.25 in November 2017, the lowest the multiple had been since 2010. The stock has since recovered a bit and trades at a P/E of 28.6. Ulta still trades at a premium multiple, but thus far the company hasn't shown any signs of weakness like most retailers, remains debt free with improving cash flow production, and is growing earnings at about a 20% clip. I don't think it'd take long for the stock to grow into its premium valuation, and at the least I suspect it will be a market-beater over the next 3+ years. Another one to watch.

Alright... a lot of thoughts and ramblings there. Over the past year I've made it a priority to keep an investing journal to document my thoughts, expectations, and notes as to why I buy (and rarely sell) a given stock. This post is an extension of those notes, observations, and some initial takeaways. For me, the bottom line is that if I find a company with these traits...

-- improving earnings and cash flow production
-- a healthy (ideally debt-free) balance sheet
-- a proven track record and management team
-- clear prospects for future expansion

... my interest will be piqued as an investor. If you can get all those traits and a substantial dose of shorter-term market pessimism, I think you increase your odds of generating market-crushing returns.

Much more to be learned in 2018 and beyond. Thoughts always welcomed and appreciated. :-) Any companies you see that fit this type of framework and might be worth a closer look?

David K
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