Aeropostale (ARO): Part Four – Shleifer and Ackman

February 17, 2012 — Leave a comment

As we discussed previously, Professor Andrei Shleifer’s Inefficient Markets provides an instructive lens for viewing the past year or so of Aeropostale’s business operations and ensuing price volatility.

In short, investors watch a business, evaluate its performance, and form an opinion that tends to extrapolate its recent performance into the future. This tendency is called representativeness.

Once they form an opinion, they stick with it even in the face of disconfirming evidence. This is called conservativeness, and it remains the case until multiple pieces of evidence finally overwhelm them and force a change of mind. Investors then fall prey to overreaction – classic Mr. Market – getting overly excited about a company or depressed about it and pushing its price up or down (whichever the news may warrant.)

The concept passes my reasonable man test for how people (I’ll include investors in this category) behave, and so I’ll graft it on top of what we’ve observed with ARO to see what we can learn.

First, let me step back a little for an aside (albeit a long one) that I think drives home the point. A few months ago I watched a re-broadcast of the Fourth Annual Pershing Square Challenge at Columbia Business School. It took place in April 2011 and features teams of business student presenting their best investment ideas to Bill Ackman and a panel of judges. (Thanks to Value Walk for posting the video. You can access it here.)

One team pitched ARO at 26.00 and the judges (Ackman in particular) laid into them with their critique. As I’ve developed my ARO thesis, I’ve returned to this critique to challenge my own thoughts for the investment. (Another gratuitous hat tip here to the excellent blogger, Greg Speicher, who suggested this very thing in a recent post you can find here.)

The students highlight how ARO has several years of excellent – yet improving – operating metrics, making it a best in class business model for mall-based teen clothing retail. The team shares much of my view on the strength of the business model, and argues that – based on growth potential of the P.S. concept plus international growth plus ecommerce – this business is worth $34 per share.

The judges bring up pertinent objections such as…

1. The risk of being a copycat of Abercrombie & Fitch, especially if the Abercrombie style falls from teenager fashion grace. This lack of diversity sinks the business. So, how confident can an investor be that a.) style stays the same, and/or b.) ARO has the ability to adapt to any change in fashion?

2. The risk of shocks to the system disrupting a low margin business. Specifically, can the value retailer in this space with such low gross margins  either a.) absorb increased cost of goods sold while remaining an attractive investment with strong earnings,  or b.) pass the costs along to customers without losing its value-price halo? This is particularly important in regards to cotton price increases, a key input for a clothing retailer.

3. The best critique came from Ackman himself and belied an understanding of retail dynamics born of deep experience. After the team suggested that the worst case on the downside would bring a ten percent decrease in the $26 price, Ackman implied there is always much more risk investing in a retail business where existing investors have become acclimated to quarter after quarter of unabated good news (i.e., comp store increases). If they get an earning surprise or two, they would head for the exits and take the stock price down dramatically in the meantime.

Ackman’s comments:

“If this is a stock that has never had a down comp and it starts comping down…something that’s going to change is the multiple people are willing to assign to their earnings. So I think the downside is much greater than what you say.

“I’ll give you the most skeptical argument I can make of the company…which is: you have a business that doesn’t do anything proprietary, they’re basically stealing other people’s intellectual property and just reproducing it with a lower quality product. Their margins are much slimmer and being squeezed by commodity prices.

“There isn’t much opportunity for growth and there is question about the growth of their competitors who they’ve been leaching off over time. If you have same store sales declines and margins decrease, profitability is going to drop significantly because of the large operating leverage of the business…

“The combination of those factors, I think you could lose a lot of money on this stock.”

And look how prescient Ackman’s comments were. ARO dropped from $26 to $21 just a month later on the announcement that Q1 2011 fiscal year comps were down seven percent. And management dropped guidance for the next quarter to boot. From the date of the presentation in April through October, the stock plummeted to just over $9 per share. A multi-year low for ARO.

Ackman understood what Shleifer was saying, and the point underscores much of the thinking behind value investing. When you invest in a business whose owners have become accustomed to nothing but success, bad news in the form of a couple missed quarters can send the stock price tumbling.

It is now, in Shleifer’s terms, an extreme loser. And extreme losers that survive over the long haul tend to do much better than extreme winners. According to Shleifer:

“…over longer horizons of perhaps three to five years, security prices overreact to consistent patterns of news pointing in the same direction. That is, securities that have a long record of good news tend to become overpriced and have low average returns afterwards. Securities with strings of good performance, however measured, receive extremely high valuations, and these valuations, on average, revert to the mean.”

With Shleifer’s work we see a compelling case of human behavior grafted from psychology to investing in which human tendencies toward conservatism and representativeness cause overreaction. The prevailing sentiment becomes one of a trend continuing (i.e., even more same store sales declines) rather than a level headed view of the business’s future prospects.

If I bought ARO at $26, as the Columbia students recommended, I confess readily that my own ability to assess the affairs of the business would be severely compromised by the system shock of seeing nearly 70 percent of my investment value disappear. Though I believe I have somewhat of a strong stomach, my hard-wired tendency toward representativeness (the bad trend will continue) would likely overpower my rational ability to be calm, cool, and collected in thinking about the future. It would be excruciating not to join the stampede of investors rushing for the exits. Indeed, even if I could have mustered the courage to survive the first two or three earnings disappointments, my resolve would have weakened with each ensuing miss.

So Ackman proved prescient: investors who came to expect even sunnier prospects for ARO as a best-in-class retailer threw themselves overboard as the business future earnings became more difficult to discern.

That has now passed.

As we said, the job of investors at this point is to gaze deep into the business and decide whether the clouds of uncertainty can be penetrated.

Paul Dryden

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