Beware the 'Pull Forward'

Here's a news flash to all the unwavering "value" investors out there...

The stock market loves growth.

The higher and more consistent the growth, the better. Consider the following...

There are roughly 5,500 publicly traded companies in the U.S. with market caps of at least $50 million. Over the past five years, the top 10% of these companies have averaged annual revenue growth of more than 20%. The bottom 10% of the bunch have seen their revenues decline on average(or annual revenue growth of less than 0%).

For that five-year period, shares of the fastest-growing stocks have more than doubled on average, with total returns of 103%. Shares of the no-growth bottom-dwellers averaged 8% declines in total returns.

The stock market really loves growth. But sometimes, that obsession can lead to trouble.

No business leader in recent history knows that better than Kevin Plank, the founder of athletic apparel maker Under Armour.

Plank was notoriously hyper-focused on his company's growth rate as he worked to make Under Armour "the best sports brand on the planet." In October 2016, the company recorded its 26th consecutive quarter of at least 20% sales growth. Plank explained the importance of that streak in an earnings call...

Our financial results are an incredible accomplishment for any brand and something that we believe separates us from others in our business. I don't know if there's ever been another model like ours with the growth we've seen over the last 6.5 years, particularly in [the] consumer [sector].

Unfortunately for Under Armour and its shareholders, that quarter marked the last time the company would ever grow anywhere close to 20%. The following quarter, sales growth dropped to 11.7%. Over the next three quarters, it averaged just 3.6%. In 2019, it averaged sales growth of just 1.4%.

Under Armour shares dropped, too... from a high of $47 in 2016 to a low of around $9 today.

So what happened? How did the sales growth drop so much, so quickly? And what can Under Armour's mistakes teach us about the overall market today?

A major contributor to the abrupt shortfall was Under Armour's practice of "pulling forward" sales orders. That's when you claim revenue now that you would have otherwise earned in some later period.

Knowing how important sales growth of at least 20% was to Plank, executives at Under Armour made every effort to hit that mark each quarter. Per the Wall Street Journal, an unnamed executive admitted...

It was a pretty common practice to pull forward orders from the month after the quarter to ship within the quarter in order to hit the number or close the gap.

That was fine at first – and not illegal – as long as the pulling forward only occurred occasionally and the customers willingly approved placing their orders early.

But problems began to mount when the pull-forwards became more frequent. The same executive explained: "We found ourselves pulling forward sales every quarter."

At the end of 2016, the pull-forward tactics collapsed when Under Armour's largest customer, Dick's Sporting Goods, abruptly stopped taking products early. Its management team was upset by Under Armour's decision to sell lower-priced products through discount channels like T.J. Maxx and Kohl's. And just like that, the jig was up.

As Harvard Business School Professor Ethan Rouen explained after researching the company's pull-forward strategy, "If you're mortgaging the future, it's eventually going to catch up."

What We Can Learn From Under Armour's Sales Tactics

The Under Armour pull-forward strategy is important to consider for two reasons...

First, it's a great example of why the Stansberry Portfolio Solutions Investment Committee – and all our editors at Stansberry Research – is so focused not only on seeing robust growth in revenue, but also in free cash flow ("FCF").

FCF is the profit left after a company pays all expenses, including capital expenditures. The more FCF a company produces, the more cash it can return to shareholders through dividends and buybacks. Sales growth alone can power stocks higher for a while. But over the long run, growth in FCF generation is what's most correlated to outsized shareholder returns.

Therein lies the issue with a company like Under Armour. Let's look at the seven-year period from 2009 to 2016. Sales grew by more than 460%, but profit margins fell. This led to earnings growth of just over 300%, but a decline in FCF.

In Portfolio Solutions, we want to find businesses with scale advantages that improve margins and FCF rates over time. We want businesses that become more capital efficient as they grow. In other words, we want to invest in businesses that get better as they get bigger.

The second – and timelier – reason to examine Under Armour's sales tactics directly relates to what we're seeing in the market today. In short, the current unprecedented levels of monetary and fiscal stimulus by the U.S. Federal Reserve and U.S. government are pulling forward future gains in both equity and debt markets. This will have profound consequences for investors going forward.

To be clear, I'm not arguing that bond and stock prices should be much lower than they are right now. As I explained last month, the two most important factors for stock prices currently are incremental data on COVID-19 and the stimulus provided by the Fed (and U.S. Treasury).

The data on COVID-19 have improved, and the Fed has confirmed it will provide a "limitless" supply of liquidity to backstop the economy. So the worst-case, doomsday scenarios the market feared in March are effectively off the table.

In addition, as central banks around the globe buy bonds and push investment yields lower (including negative interest rates), the TINA ("There Is No Alternative") argument for stocks grows louder. In other words, in a world with virtually no options for generating income safely, many investors are choosing to push more money into pricey stocks.

After all, even with an increase of more than 35% from the March lows, the dividend yield on the S&P 500 is still more than twice that of the U.S. Treasury 10-year note. So it's reasonable to conclude that the recent market move higher is justified.

But it's also reasonable to conclude that the tremendous gains we've seen off the bottom are necessarily pulling forward at least some future returns, particularly against a backdrop of truly terrible economic data.

The stock market can and should look through short-term blips in the economy and be valued more on the long-term earnings power of its companies. But it seems increasingly likely that the current economic downturn is not just a short-term blip.

Wall Street estimates for corporate earnings in 2021 and (even 2022) have declined in recent weeks. As we continue to see a rise in corporate default rates and bankruptcies, expect those earnings estimates to fall more. And if a second wave of infections occurs that requires another forced shutdown of economic activity, we'll see earnings estimates and stocks drop further still.

In short, in order to justify the current prices for the broader stock market, investors must be comfortable doing two things...

1. You must look into the future much further than typical to assess "normalized" earnings power for the economy as a whole.
2. To do that, you must have complete faith in the power and creditworthiness of the U.S. government to get us from here to there. I see no reason to doubt the power and sustainability of the U.S. government for the foreseeable investment horizon.

What the Pull-Forward Means for You

Given the increasing probability of an extended and deep economic downturn, the current risk-to-reward ratio for stocks is less favorable than it was a year ago, even with the added government stimulus.

Nevertheless, given higher relative yields and the prospects for eventual earnings growth and recovery, we continue to favor stocks to bonds for most investors and investment dollars.

Investing in the current market requires an extremely long-term outlook and holding period to be confident in a positive outcome. As such, we recommend you extend your investment horizons, lower your return expectations, and adjust your spending and saving habits accordingly.

On a related note, we have no interest in making short-term market bets. But if forced to make a prediction, I continue to believe a decline of 15% from current prices is more likely than a gain of 15% over the next 12 months.

We recommend you continue to invest in portfolio protection and hold more dry powder than normal. For those reserves, I strongly prefer gold to cash. The world is printing more dollars and other currencies than it is mining new nuggets of precious metals.

Finally, while the overall market might have pulled forward gains, I'm reminded of the adage: "It's a market of stocks, not a stock market." In other words, opportunities exist to make attractive gains by buying high-quality growth stocks with enduring businesses at reasonable prices. We remain committed to doing exactly that.

Thank you for your continued trust,

Austin Root, on behalf of
Porter Stansberry, Dr. Steve Sjuggerud, and Dr. David Eifrig
June 2, 2020

April's Green Shoots of Hope Blossomed in May

The stock market recovery that began in mid-March powered ahead in May...

The S&P 500 Index has recovered roughly 36% of its value since the March 23 low. The Nasdaq Composite Index is up 38%, and the Dow Jones Industrial Average is up 37% in the same period.

There were two main drivers of this recent strength: economic restarts and coronavirus-related vaccine trial data.

The World Is Turning Again

As we saw in late March, economies all over the globe began to shutter in an effort to limit human interaction and stop the spread of COVID-19. In April, the outbreak appeared to peak in many areas. And as we discussed last month, struggling economies began phased reopenings.

As the number of daily new infections continues to decline, economies are upping the stakes. So far, 11 European countries have agreed to resume cross-border travel for European nationals beginning in June.

According to the World Tourism Organization, first-quarter international tourism dropped 22% in the European Union ("EU"). The industry is an important one for the area. In 2018, tourism accounted for roughly 4% of the EU's gross domestic product. It also made up around 11.9 million jobs, or 5.1% of the workforce. But when considering the cross currents with other sectors – like dining and retail – those numbers inflate to 10.3% of GDP and 11.7% of total employment.

If economies and borders continue to reopen successfully, that should be a positive for the regional and global economies. It means one of the region's key industries can resume activity. It would resuscitate global demand for all types of goods and services, notably travel-related items such as trains, cars, flights, and fuel.

Here in the U.S., all 50 states have begun to lift their shelter-in-place restrictions.

The first was Georgia. The nation watched as – against advice from the federal government and criticism from the media – Georgia allowed small business to resume operations in late April.

California has not lifted its stay-at-home order. But the state is cautiously reopening on a county-by-county basis. As the largest piece of U.S. GDP (at roughly 14.5%) and the fifth-largest standalone economy in the world, California's reopening is a crucial step in reviving the domestic and global economies.

New York is another important part of the national economy. The state contributes 8.2% of U.S. gross domestic product. It said it would begin to reopen the state in a phased process, starting in the upstate region. And New York City should reopen in mid-June.

The overriding concern as states reopen remains a "second wave" of new infections, like we saw with the Spanish Flu in 1918. But so far, the trend in new COVID-19 cases is still down. And vaccine developments should help to ease those worries...

Three Promising Vaccine Candidates

Biotech company Moderna put out a press release noting eight of the 45 patients in its Phase I study showed the same level of "binding antibodies" as patients who have recovered from COVID-19.

In other words, Moderna's vaccine can produce antibodies that defend cells by neutralizing the effect of the virus. That means the invading pathogen is no longer infectious. It labeled the dosage as "generally safe and well tolerated."

National Institute of Allergy and Infectious Diseases ("NIAID") Director Dr. Anthony Fauci said the information from Moderna's study was rushed and is not complete. It is currently being reviewed by his team at NIAID, and the final results should be released to a peer-reviewed journal in a few weeks.

But after personally reviewing the findings, he is excited about the early Phase I vaccine data. He called them "quite promising." It's still early in the discovery process, but he believes – assuming there are no roadblocks – we could have a vaccine ready for deployment as soon as the end of this year or early 2021.

Moderna has already received approval for Phase II trials. And the NIAID director anticipates accelerated Phase III trials will begin early this summer. These will both test for safety and efficacy.

Another biotech company, Inovio Pharmaceuticals, is optimistic about its preclinical study data. On May 20, Inovio announced its COVID-19 vaccine candidate generated binding and neutralizing antibodies in mice and guinea pigs – which indicates it could do the same in humans.

Inovio anticipates preliminary Phase I trial data to be released in June. It expects Phase II and Phase III trials to start in July or August, pending regulatory approval.

Another study conducted by pharmaceutical company AstraZeneca and the University of Oxford over in the U.K. has received approval to move forward to Phase II. In fact, the U.S. government announced recently that it's investing more than $1 billion in the study.

And these aren't the only potential vaccines – they're just the three with the best chance of success right now. There are more than 100 candidates in the pipeline.

An effective vaccine would go a long way toward helping the economy recover. In a May 17 interview with 60 Minutes, Federal Reserve Chairman Jerome Powell said the economy may not see full recovery until we have a vaccine. That's a big reason why Fauci said we'll begin production of these inoculations before trials are complete.

This is a highly unusual order of events. But then again, we're living in highly unusual times. Early production means that shots can be administered soon after approval. Fauci's hopeful there will be multiple successes on the trial front to increase the available options.

The growth outlook for the world economy is dependent upon containing COVID-19. The sooner the medical community can develop an effective vaccine or treatment, the sooner we can feel more comfortable about resuming our "normal" daily routines... and the sooner economic activity everywhere can return back to maximum output. That should help drive the outlook higher for corporate earnings and equity markets around the globe.

Best investing,

C. Scott Garliss
Lead Analyst, Stansberry Portfolio Solutions

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