Here's Why You Need to Listen to the Opposite Side of the Trade

A few days before the company was set to report its first-quarter earnings, an anonymous member of the Value Investor Club ('VIC') posted a write-up pitching lingerie retailer Victoria's Secret (VSCO) as a short... Shorting stocks makes money when they go down. I have been vocally bullish on Victoria's Secret for more than two years […] Not rendering correctly? View this e-mail as a web page [here](. [Empire Financial Daily] Here's Why You Need to Listen to the Opposite Side of the Trade By Berna Barshay --------------------------------------------------------------- [The hottest $4 stock in June]( The legend who bought Amazon at $48 and Apple at $0.35 is pounding the table on a [$4 stock](. --------------------------------------------------------------- A few days before the company was set to report its first-quarter earnings, an anonymous member of the Value Investor Club ('VIC') posted a write-up pitching lingerie retailer Victoria's Secret (VSCO) as a short... Shorting stocks makes money when they go down. I have been vocally bullish on Victoria's Secret for more than two years now, dating back to my first Empire Financial Daily essay on its [predecessor company L Brands back in May 2020](. L Brands has since spun off Victoria's Secret as a separate company and now trades under the name of the retailer that remained – home fragrance product chain Bath & Body Works (BBWI). It has been a wild ride for VSCO shares since the spin-off last summer... They soared in the immediate aftermath of the spin-off, later stabilizing lower – but still with healthy gains. But as investor appetite for retailers soured this year as interest rates and inflation soared, this once very in-favor name couldn't buck the gravitational pull lower that has been affecting the whole retail sector. Take a look... VSCO shares are down 27% since the beginning of the year, roughly in line with the SPDR S&P Retail Fund (XRT), which is down 26%. Retail has been the absolute worst sector this year – greatly trailing the performance of the large-cap S&P 500 Index, which is down 13%, and the small-cap Russell 2000 Index, which is down 15%. Between the dual headwinds of rising rates and higher inflation, the continual challenges of managing the supply chain, the lapping of last year's stimulus checks, fears of a coming recession, and the shift from spending on things to spending on experiences as the pandemic moves into the rearview mirror for almost everyone... retailers have been very out of favor. Victoria's Secret is in the middle of what I think is a very impressive turnaround under new management that took over in the last couple of years. Despite a big improvement in sales trends and operating margins, the shares were not immune to the negative sentiment affecting the sector. As a result, shares were trading at a price-to-earnings (P/E) ratio of only about 5 times when the short report was published. The ratio of enterprise value to earnings before interest, taxes, depreciation, and amortization (EV/EBITDA) was an equally unchallenging 4 times. These are very low valuations, reflecting investor expectations that earnings estimates are too high and will need to come down. But even with a big haircut to earnings, VSCO was a cheap stock – so I was curious what the case would be for shorting such inexpensive shares. Sometimes "cheap" stocks can be great shorts. If a company is in secular decline and is on its way to go live with the dodo birds in extinction, then shorting something "cheap" is a good strategy. But few would argue Victoria's Secret is at risk of going bankrupt and disappearing... so I was curious. --------------------------------------------------------------- Recommended Link: [This could be a game changer for Amazon]( Put yourself in Jeff Bezos' shoes. You can do anything. Buy anything. Travel anywhere at a moment's notice. And yet... there's one thing that he hasn't been able to do – get his hands on a certain technology. If he does, Amazon could tap into a brand-new $300 billion industry where half the planet plans to spend MORE money over the next five years. You won't believe it unless you see it for yourself. [Get the full details right here](. --------------------------------------------------------------- Investors who are long a stock should always be willing to hear the short case... It's presumptuous to believe you know everything possible about any given stock or company. Even with a company that I have followed for decades like Victoria's Secret, I certainly could have missed something. While some people think shorting is a nefarious activity rife with market manipulators – I don't subscribe to that philosophy. The short sellers I know – and I used to be a very active one when I worked at hedge funds – are some of the most intellectually honest and analytically rigorous investors I know. So I never say no to hearing the short case. A handful of times across my career, a great short case has shaken me out of a long position. I struggle to think of a time when I regretted the exit. More often, I have heard the bear points, filed them away as duly noted, and not sold my shares... but perhaps kept an ear closer to the ground regarding the red flags the short seller had highlighted. I think it's foolhardy and often arrogant to not hear out opinions opposite from yours. I vividly recall a situation when an investor at a small fund told me he had uncovered evidence of fraud at a giant, large-cap, household-name kind of company. I happened to know an analyst who worked for a huge asset manager with hundreds of billions of dollars under management who was responsible for his firm's sizable position in the stock of said company, which totaled in the hundreds of millions of dollars. I offered to introduce my friend proclaiming fraud to the analyst who owned so much of the stock. But he refused to talk to the short seller, insisting that the guy was just trying to shake him out of the stock to make it go down. I didn't see what harm there was in just listening, but he was adamant that he wanted none of it. The stock was WorldCom... Those with long memories will know that it didn't end well for the guy with a nine-figure investment in that stock. David 1, Goliath 0. Back to Victoria's Secret... The crux of the short thesis was four-fold... - The credit-card data showed that sales were declining and getting worse. Other data showed that website traffic was down. I couldn't argue with this – the data says what the data says. The credit-card data that various research shops sell is based on certain sets of credit cards and almost certainly wouldn't include the Victoria's Secret store card. Any time you're using a subset of data to extrapolate how all the data looks, there is a sampling error. That said, the data looked bad... and I couldn't argue with it. - The short investor cited cost issues and inflation. I couldn't argue with that either. But the fact that the stock was already trading at a P/E ratio of 5 times and was down around 30% this year said to me that earnings revisions downward were totally expected and already priced into the stock. - The writer noted that private equity firm Sycamore Partners had valued Victoria's Secret at $1.1 billion just before the pandemic, and now it trades at an enterprise value of $4 billion. True... but I already have stated that I think [Sycamore panicking during the early part of the pandemic and breaking its deal to buy Victoria's Secret]( for a billion dollars was one of the greatest private equity whiffs I have ever seen. I'm not taking any cues from what Sycamore thinks about this company. - The author stated that Victoria's Secret was alienating its core customer with its marketing moves that emphasized more racial and size diversity. This was so off base to me – it clued me into the fact that the author may know the numbers of the financial statements, but he doesn't know anything about what's happening with this company on the ground. When I responded to my colleagues about the short report, here's what I wrote... Numbers are too high and the stock may very well go down before it goes up – perhaps materially – unless the market has bottomed and people look through any current weakness. That's what makes this a macro call. His micro analysis is completely unnuanced, but he might be right on the macro. But retail is an early cyclical and tends to bottom before the results do. If I was trading, I would think a lot about this. In this context [writing a long-term-oriented newsletter], it is a pretty useless mental exercise... Trying to figure out the trajectory is a waste of time. The guy is putting a $7 target on this because Sycamore did – that's evidence he doesn't understand the business. This was always one of the highest margin apparel retailers for decades for structural reasons (real estate, market share/scale, early direct-to-consumer heritage with the catalog as well as early online efforts, and most of all, the nature of the bra category). Operating margin recovered from 1% to 13%, which would seem COVID bubble-y unless you looked at the long history of them being at 15% to 18% then going to 0%. He says the stock doesn't have a long-term chart... but he isn't looking at long-term segment financials, which are available if you look at the old L Brands. And he doesn't acknowledge any change in the business other than the new marketing, which he implies is bad (which is completely out of touch). In summary, he may be right about the next move but that depends on the direction of the market more than anything else. []Victoria's Secret ended up reporting sales in line with forecasts and beat earnings estimates handily a few days later... Revenues of $1.5 billion were down 5% year over year but at the high end of the previously communicated guidance range of down 4% to 8%. So these results weren't good in the absolute, but they were good relative to what Wall Street was expecting... and they certainly weren't as bad as the credit-card data suggested they could be. Adjusted earnings per share ("EPS") came in at $1.11 versus consensus estimates of $0.84, aided by some very good discipline on the cost side. The stock went up 9% the day after results were released. To be fair, the shares are a bit lower than when the write-up was posted – but the drops have been market-related. When there was company-specific news, the shares went up... reinforcing my take that this is more of a macro short than a micro short. Victoria's Secret is hardly out of the woods... It's facing inflation in its product costs as well as in freight and labor, and the guidance for second-quarter sales to be in the range of up low-single digits to down low-single digits seems a little aggressive versus the first-quarter results given what we know about consumer trends right now. If I was still at a hedge fund, I would stress the quarters a lot more. But I'm thinking about where this stock will be in three years – not where it will be in three months. Time frame is important in investing... We could both be right. The author of the piece could make 20% on his short at some point this year, and I could make 75% on my long in three years... We both "win" in that scenario relative to our investing goals. I'm willing to risk short-term volatility because in the longer-term, I am confident that it is still the middle innings for the turnaround. Victoria's Secret is doing all the right things with the marketing... and after years of turning off young women, the company is again appealing to them. One thing the short seller said struck me as so wrong that it encouraged me on the long case for the stock. He wrote... They have likely alienated their core customer by replacing aspirational angels with plus size models. Using outspoken feminists as brand ambassadors is unlikely to quickly turn new customer sentiment. To contextualize what we're talking about, here's what Victoria's Secret marketing looked like until a couple of years ago... Source: Fashionista.com Here's what it looks like now... Source: Instagram/@victoriassecret I think the short seller has a bad take on the marketing. There is empirical evidence that the move to embrace more diversity in picking models, more size inclusivity, and embracing all aspects of womanhood – such as motherhood by selling maternity bras for the first time – and not just the sexy stuff is all resonating. And I am confident that I understand what the young women that Victoria's Secret is targeting want better than a man who has never shopped there, even if I'm not in that target demo for the company anymore. As I wrote to my analyst Alex Griese, "I think a lot of men let their own personal aesthetic preferences and their politics blind them to what is working here." In that sentence is an investing lesson that goes far beyond the conversation about Victoria's Secret. In our increasingly polarized world, it's important to remember that we don't have to like something or approve of something for it to be a profitable investment. I'm personally not a fan of health management organizations ("HMOs")... Despite what they say, I don't think they improve the efficient delivery of health care. But it's how the system works, and it is probably going to stay that way... So I have owned them, and even recommended one as part of our Empire Stock Investor newsletter. I could give a dozen more examples like this, but there's no reason to give readers 12 more things to argue about! Suffice it to say, be aware of your own personal blind spots when investing... and always be willing to []listen to what the other side has to say. I'll be back with the mailbag tomorrow... Do you think retailers aren't investable right now, given all the uncertainty about the future trajectory of the economy and the state of inflation... or are single-digit P/E ratios too tempting for long-term investors to ignore? Do you actively seek out the bear case on the stocks you own? Share your thoughts in an e-mail by [clicking here](mailto:feedback@empirefinancialresearch.com?subject=Feedback%20for%20Berna). Regards, Berna Barshay June 8, 2022 If someone forwarded you this e-mail and you would like to be added to my e-mail list to receive e-mails like this every weekday, simply [sign up here](. © 2022 Empire Financial Research. All rights reserved. Any reproduction, copying, or redistribution, in whole or in part, is prohibited without written permission from Empire Financial Research, 601 Lexington Ave., 20th Floor, New York, NY 10022 [www.empirefinancialresearch.com.]( You received this e-mail because you are subscribed to Empire Financial Daily. [Unsubscribe from all future e-mails](