The Market is Bidding Up Winner-Take-All Cash Flow Streams
The market is bidding up pandemic-proof cash flow streams. When you look at stock price behavior through this lens, the picture makes more sense.
This further implies the stock market is not reflecting economic recovery, or a “return to normal,” but rather the stark realities of a post-pandemic landscape.
To put it another way: In a world where consumer behavior has radically shifted because of the pandemic, a great many companies will be net losers, but a handful of companies will be significant winners, absorbing market share from the also-rans.
The slow death of the real economy, meanwhile, can actually help the companies that are winners, by eliminating competition and amplifying the value of pandemic-proof execution strategies.
Think what happens, for example, if millions of retail-oriented small businesses shut their doors forever, even as tens of thousands of medium- and large-sized retail businesses see their traffic and sales numbers decline.
Overall, that sounds like a grim forecast. From a total economy perspective, it certainly is.
And yet, imagine the fortunes of a big-box retailer, with a well-developed e-commerce strategy, that is able to capture the lion’s share portion of the business that remains.
What you get is a decline on the whole, but increased revenue and profits for the last winners standing. If a top-tier big-box retailer can wind up with a bigger piece of a smaller pie, they come out ahead.
This is exactly what we saw with Target (TGT), a big-box retailer that reported its strongest quarterly earnings in history on Aug. 19.
It seems strange to think a retailer could see its best results ever in the midst of a pandemic — until you think of all the other retailers who either shut their doors or failed to execute a pandemic-proof strategy. In that respect, competitors’ pain was Target’s gain.
In a pandemic, consumers want to reduce their exposure to physical shopping trips. When a physical shopping trip becomes a must, they want the ability to pick up a diverse array of necessities in one place, so as to reduce the number of trips. If they can pre-order items online and have a store employee put the stuff right in their trunk in the parking lot, so much the better.
Target had all of this figured out, mainly because their business model was already geared for it.
Target has long been a place where you can buy groceries, clothing, hardware, and patio furniture, all in the same store. Target’s reported sales pick-up across multiple categories, from food to electronics to home goods to clothing, showed the extent to which consumers decided that, rather than visiting multiple stores as they might in the past, they would just go to Target.
Target also had the smarts to heavily invest in its e-commerce strategy well before the pandemic hit.
It is not just hard, but almost impossible, to get a high-quality e-commerce strategy up and running quickly. Doing it right takes patience, capital, and logistics. Target had already done the work, and the pandemic payoff was major: In its latest earnings report, the company reported online sales growth of nearly 200% year-on-year.
To see the difference between winners and losers, one can compare Target to all of the retail names that have gone bankrupt in recent months: JCPenney, Stein Mart, Lord & Taylor, Brooks Brothers, JoS. A. Bank (the owner of Men’s Wearhouse), and more.
One can also see a stark difference in price performance between Target (TGT) and, say, Kohl’s (KSS) or TJX Companies (TJX), two retailers that were punished for their e-commerce gap.
Target isn’t necessarily a buy, as of this writing, because the stock price has already exploded higher. But one of the lessons we can draw from Target is that, while the valuation multiples may feel extreme, the market’s assessment of pandemic-proof cash flow streams has a rational logic to it.
Business models that can win during a pandemic — and are likely to keep on winning for the foreseeable future — are likely to see a significant premium attached to the cash flows they generate, in the form of a higher valuation multiple and a well-supported stock price.
At the same time, companies that are considered second-tier, with cash flow streams more vulnerable to disruption or decline, are likely to be left in the cold.
Then, too, as far as the real economy goes, winners can benefit from reduced competition as the other guys shut their doors. In a brutal economic downturn, with marginally profitable retail players at risk of being wiped out, the “winner take all” effect could boost the Targets of the world even more.
If there is a takeaway theme here, it is something like Warren Buffett’s “moat,” in terms of cash flows supported by a competitive edge or business model advantage that is very hard, if not impossible, to beat.
Except today’s moat is more dynamic than static — more about execution, strategy, and technology than branding or positioning — and the comparison to historical valuation multiples has to be ignored. In these respects, it is a growth-investing environment, and even more so a trading environment, but not a value-investing environment at all.