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Long/Short Investments in L/S Equity: Valuation and Ideas,

Inside The Market’s Top Consumer Discretionary Fund

In the US, nearly $14 trillion is spent each year. Companies spend a lot of money implanting it in consumers' minds that they need to spend money on various products, much of which is discretionary. Although the rise of technology over the past 20 years has made technology companies the most valuable, retail is still very much the basis of most. 

The world's most valuable company, Apple (AAPL), is generally labeled as a technology company, but is very much consumer discretionary in terms of the products it sells. Google (GOOG) and Facebook (FB) specialize in advertising, which is mostly geared toward helping retailers sell their products and services. Microsoft (MSFT), through its hardware and cloud offerings, helps companies become more efficient. Amazon (AMZN) and Alibaba (BABA), sometimes referred to as tech companies of sorts, have their core business focus as mega-retailers taking over the industry through their top-of-the-line transaction platforms.

The consumer discretionary sector has a +0.93 correlation with the overall equities market. Naturally it’s also more volatile – by about 20% – as buying the market as a whole provides some inherent level of hedging. As the name suggests, companies generally labeled under the term sell products or services that consumers don’t necessarily need for day-to-day living. Examples include restaurants, luxury items, travel, entertainment, among others. Accordingly you might expect them to be more cyclical.

Asset distributions in consumer discretionary funds also tend to be more equitable, with less concentration at the top. In Vanguard’s Consumer Discretionary ETF (VCR), there are 379 holdings. Roughly 45% of the weight is held in the top 10 assets, which is on the moderate-low end; 54% is held in the top 15 and 75% in the top 50, both of which are low.

Concentrations are much higher in technology and biotech, where achieving scale has tended to be more important. For example, Fitbit has dropped off heavily given large conglomerates 500x the market cap can simply copy their technology. And natural monopolies – such as in search and social networking – are more apparent.

In retail, Amazon (AMZN) is forging its own monopoly by becoming the go-to leader for all things retail. But certain pockets remain where it will be difficult for Amazon to disrupt unless it goes there directly. For example, retailers that appeal to lower-income consumers, such as dollar stores (e.g., DG, DLTR) are fairly safe given many who shop at these outlets may not have the banking resources or internet access to shop online, or places for safe package delivery.

On the other side of the spectrum there is luxury. It’s rare for individuals to make expensive purchases without first trying out the item in person. This goes also goes for appliances, furniture, and obviously for big financial decisions involving cars and homes.

Restaurants are another non-Amazon area, but is already subject to a high level of competition. Brand loyalty is generally low, especially in fast casual, leading to competition on the basis of price.

Overall, the playing field is still relatively fair. Amazon takes up about one-eighth of the index. After that comes Comcast (CMCSA), Home Depot (HD), and Walt Disney (DIS), each with representations between 5% and 6%. Eight companies have 2%-4% weighting: McDonald’s (MCD), Priceline (PCLN), Starbucks (SBUX), Time Warner (TWX), Charter (CHTR), Nike (NKE), Netflix (NFLX), and Lowe’s (LOW).

Auto manufacturers Tesla (TSLA) and General Motors (GM) come in at 13th and 14th with weights at around 1.5% of the index.

All of these companies are household names with market caps of at least $50 billion, with most above $100 billion. Given ETFs are constructed with the buyer of the product in mind and given that large cap companies are in higher demand, the weightings naturally reflect this.

On the second page we see Ford (F), 21st Century Fox (FOXA), Target (TGT), Yum! Brands (YUM), and Dollar General (DG). The second page, naturally, generally reflects second-tier quality retailers. Ford is having issues with investor concerns of toppy-ness in auto sales, burgeoning auto debt, and high amounts of capital expenditures as the race for self-driving technology heats up.

Following we have such companies as Expedia (EXPE), Ulta Beauty (ULTA), Dollar Tree (DLTR), Best Buy (BBY), and Dish Network (DISH).

Expedia is more likely ripe from disruption from Airbnb, as Amazon hasn’t at all penetrated online travel. Ulta has been one of the market’s big gainers since the market lows in March 2009 and specializes mainly in women’s beauty products and fragrances. As a brick-and-mortar chain, it provides an experience that can’t easily be replicated online.

Best Buy was a struggling company a few years ago, but has revamped its customer service and provides appliances and other electronics that people prefer to see and/or test out in person before buying. Whirlpool (WHR) and Aaron’s (AAN), other names on the list, fall into the same category.

Dish and cable providers more generally are facing headwinds from widespread consumer cord-cutting. Consolidation in the industry – both for scale and diversification – is becoming more common.

Several car parts manufacturers are on the list, including Carmax (KMX), O’Reilly (ORLY), Autozone (AZO), Genuine Parts Company (GPC), AutoNation (AN), and Advance Auto Parts (AAP). Some have been bullish on these companies as the average automobile age increases with time. Naturally part of this comes with technological improvements, which would seemingly be of no value to such companies. But at the same time, if cars are more durable and depreciate less rapidly, consumers are going to be content replacing parts to a vehicle rather than choosing to make the investment in a new vehicle entirely.

Sirius XM Holdings (SIRI) has made major strides in recent years and is virtually a monopoly in car radio. It has a 0.27% representation in the fund.

Several clothing retailers are represented, including Macy’s (M), Gap (GPS), Bed Bath & Beyond (BBBY), JCPenney (JCP), Urban Outfitters (URBN), Dillards (DDS), Sears (SHLD), among many others. Many have pulled the plug on their holdings in mid-retail as their market share recedes due to online sales. Retail malls aren’t likely to disappear completely but can rather be transformed into separate venues, which may provide some levity to REITs with commercial mall portfolios. But many of the stores that inhabit them are likely to disappear in time.

Homebuilders Lennar (LEN)(LEN.B) and PulteGroup (PHM) and mostly dependent on the credit cycle and trends in population growth. Most of these companies had big run-ups from 2000 to 2005 (often around 10x) as homebuilding surged in the US, only to fall back to around 10% of their original prices by early-2009 as so much overcapacity came on the market due to the preponderance of sub-prime loans.

Restaurants, of which there are too many to list out independently, are one of the most competitive industries and generally have low margins. It’s nearly a $1 trillion industry in the US, or around $3,000 spent per person per year. Yet with the exception of a few, most restaurants have fared poorly in recent years as establishing competitive advantages are difficult in such a saturated space.

McDonald’s (MCD) has done well as it expands abroad and has perhaps the world’s most recognizable brand. Starbucks (SBUX) is the world’s most recognized coffee brand and reaches a wide demographic (approx. 80% of Americans drink the beverage in some form). But it’s shares have stalled since November 2015 as priced in growth hasn’t matched expectations. The food and beverage ETF from Powershares (PBJ) has been on the market for more than twelve years and has returned slightly lower than the S&P 500 over that time (15-20 bps), but with lower volatility and shares a +0.82 correlation with the broader market.

A complete list of the holdings is shown below. After holding #17, each stock has less than 1% representation in the fund; after holding #36, less than 0.50%; after holding #74, less than a 0.25%.