Traps Not Trusts (VNQ – Issue #14.2 – 10/02/16)

Traps Not Trustsscreen-shot-2016-09-30-at-11-31-58-am
4 Reasons to Short REITs Now



  • Major U.S. cities are seeing the fastest pace of new construction in several decades

  • The total number of hotel rooms in the U.S. will increase 10% in 2 years

  • Investors have invested a record $7.1B into real-estate related ETFs YTD

  • Rising e-commerce volumes threaten the viability of mall-based retailers


New York s skyline has become a tangled jungle of 50-story cranes swinging girders of steel and buckets of concrete. Forty new buildings will hit the market in the next few weeks, and appraiser Miller Samuel forecasts five years of excess supply by 2017. Travel to Houston and you ll see the same thing… ditto Charlotte, Portland, San Francisco, DC. Low rates have turned the American Dream into an American Tragedy as U.S. construction spending rises to within 1% of the record $1.15T high in 2005. Like the venus fly trap you couldn’t wait to watch in sixth grade biology, the approach is beguiling, the views spectacular, and unsuspecting tenants get a nasty surprise.

The exceptional volume of new projects poised to swamp markets nationally stems from a combination of low financing rates, low returns on financial instruments and an influx of non-U.S. investors looking to park large blocks of capital in hard assets. Builders have been eager to build, and investors have been eager to invest. Real Estate Investment Trusts (REITs) have become their mutual vehicle of choice, as investors have plowed a record $7.1B into real estate related funds this year, more than twice any other sector. Anyone investing in REITs today should recognize oversupply is just the tip of the iceberg. REITs will face several structural headwinds in coming months.

1. Build Baby, Build

In just one 9-block space along New York City’s far west side, developers are constructing 17M square feet of new space, the equivalent of eight Empire State buildings. Here s the take from the New York Building Congress 2016 Annual Report, Sky’s the Limit.

An amazing $40 billion worth of construction projects were initiated across the five boroughs in 2015. More new office space is being built than at any other point in the past quarter of a century. Spending on residential construction is at an all- time high and is likely to produce more than 90,000 new units between 2015 and 2017. New hotel rooms have been added at a blistering pace.


Burgeoning supply has cut investment in future NY Metro area projects by 9% this year, according to Real Capital Analytics (RCA). And it s not just the Big Apple. Nationally, RCA s 2Q overview shows gross investment in new commercial properties has fallen 16%. RCA cites declines of 49% in Houston, 29% in Atlanta, 24% in San Francisco and 21% in Chicago. Demand can only absorb so many new properties, and developers are beginning to realize they may face oversupply in coming months.


2. The Big Squeeze

In addition to the simple math of more properties coming to market without more tenants to buy/rent/lease them, loan documents analyzed by RCA on thousands of projects nationally indicate developers have financed at historically low cap rates of 3-4% (property net income divided by purchase price). This means they have to own/operate these properties at 100% occupancy for 25-30 years just to recoup their initial investment. Like LBOs of the 80s which buckled under their own weight, there’s little room for error, since the vast majority of tenant cash flow goes to paying down debt. Good luck if your building has a leaking roof, needs an HVAC repair, faces unexpected tax increases, higher insurance premiums, or struggling tenants who can’t make rent. These are all real world problems and they happen with stunning regularity. If you’ve ever bought a big house and levered it to the max, you ll recognize this is not a prudent business model, especially with so much inventory coming to market.

3. Up, Up and Away


September 20 Fed Chair Yellen told us The Committee judges that the case for an increase in the federal funds rate has strengthened and traders now put odds of a December rate hike at 55%. This is not good for REITs. Company filings show REITs fund themselves with combination of fixed and floating rate debt, and floating rate adjustments will raise overall borrowing costs. Meanwhile, a combination of sluggish economic growth and increasing supply will likely cap REITs’ ability to raise rents and/or lease prices. The resulting margin squeeze sets the stage for a potential cash flow crunch which, at best lowers effective earnings, and at worst threatens REIT dividend payouts. Bottom Line: The looming prospect of rising rates in a weak economy is bad for REITS, and rates are about to rise for several years.

4. Amazon

Total e-commerce volume in the U.S. has risen 4.5% in the past year and now accounts for 8.1% of U.S. retail sales according to the Census Bureau. By contrast, total sales per square foot at mall operator Simon Property Group Inc. (SPG) fell 2.3%. SPG is the largest mall operator in the country, and the pivot by consumers away from brick-and-mortar stores represents a very direct threat to mall operators. It’s one of the reasons why Sears/K-Mart, Macy s and Target have announced over 200 store closures this year. Fellow mall REIT operator General Growth Properties (GGP) has seen revenue decline 7%, while top line growth at SGP has slowed from 8% to 3% this year. Occupancy rates have slipped 150 basis points at each as stores close and shoppers go online. Amazon’s U.S. retail sales have doubled in three years to $82.14B.

Picture Perfect
Vanguard REIT ETF (VNQ)


Room To Fall

The easiest way to express a negative view on REITS is to short the Vanguard REIT exchange traded fund (VNQ). It holds 150 REITs and the average P/E is 34.8x, double the valuation of the S&P 500 Index. The chart is a beauty. VNQ sports successively lower highs on rising volume, which implies accelerating selling pressure as price falls.

Short VNQ in the upper 80s with a $72 target, the 12-month low. screen-shot-2016-09-17-at-11-27-27-am

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Perception vs. Reality (WFC – Issue #14.1 – 10/02/16)

Perception vs. Reality
Wells Fargo Too Cheap


  • Wells Fargo trades at multi-year lows versus peers and its own historical valuation

  • Recent concerns over falsified accounts involved fewer than 1% of employees

  • Congressmen up for re-election have turned CEO Stumpf’s testimony into political grandstanding

  • The $185M fine levied against Wells Fargo amounts to less than 1% of earnings

Wells Fargo & Company (WFC) was founded in 1851 to speed capital, information and people from New York to California by the fastest means possible. Ten years later the bank operated the first electronic money transfer service, and by 1918 its network of 10,000 offices served customers nationally. During the financial crisis, Wells Fargo generated profit for shareholders every single quarter. It was the only large cap bank whose executives testified before Congress they neither wanted TARP money nor needed it. Wells Fargo is the single strongest banking franchise in the U.S. and concern over what amounts to a charge of less than 1% against earnings has created a rare opportunity to buy this stellar company at a significant discount. Defrauding customers is unconscionable, but the bank has taken strong corrective measures. It is also highly capitalized, growing and cheap. BUY WELLS FARGO NOW.

Throughout the financial crisis I had the distinct pleasure of interviewing Wells Fargo CFO Tim Sloan, as anchor of Bloomberg’s daily 3-5pm program Street Smart. Every quarter I’d try to find something that looked off, and he’d calmly explain why it wasn’t a big deal. We’d spar good-naturedly. He knew I had a job to do, and I knew he was particularly good at his. While Citigroup Inc. (C) booked significant quarterly write-downs and Bank of America (BAC) struggled with legacy losses from to Countrywide Financial, Wells made money.

Tim is now President/COO and I write Bullseye, so talking earnings every 90 days is no longer part our modus operandi. That said, I’ve gotten to know his company pretty well over the years, and I have some thoughts of my own, especially as I look at the stock down about 10% versus the S&P 500 since June 30. For starters, the impact on results is immaterial:

  • Fewer than 1% of the bank’s 265,000 employees opened false accounts all have since been terminated
  • False accounts generated just $5 million in ill-gotten gains… equivalent to 0.01% of annual revenues
  • California’s decision to exclude Wells Fargo from municipal underwriting for one year represents less than $2 million in fees, 0.005% of annual revenues
  • Full restitution to customers affected cost Wells Fargo just $25 per false account
  • The penalty paid by Wells Fargo of $185M equates to $0.04/share, or less than 1% of 2017 earnings

This Rarely Happens
Wells Fargo Breaks Below Peers


The issue with Wells Fargo is perception, especially since grilling executives twice in two weeks provides Congressmen seeking re-election ample opportunity to grandstand in front of the cameras… Bloomberg Television took it LIVE for several hours. Perception has caused this stock to sell off, not the nominal $185 million penalty or resulting $0.04 charge to earnings. Again these amounts are immaterial to an institution of Wells Fargo’s size.

Wells Fargo underwrites roughly one-quarter of all mortgages in the U.S. Its unprecedented scale as the largest domestic lender will generate $20.4B of net income this year, based on consensus estimates. Only 40% of this amount is distributed as a dividend (currently 3.41%) and Tier 1 Capital of 12.81% is second only to J.P. Morgan among the mega-cap banks. Wells Fargo is exceptionally well-capitalized, and any concern about a possible snow-balling over loan falsification and its potential threat to liquidity are unfounded. Institutional Investor’s top-ranked banking analyst Betsy Graseck of Morgan Stanley upgraded Wells Fargo this week, writing clients:

Wells Fargo is rarely this inexpensive and this is an opportunity. We are upgrading to overweight. Recent underperformance drives Wells‘ yield to 3.4%, the highest in the group. The current multiple of 10.7x 2017 earnings provides best value among peers and offers an attractive entry point for this best-in-class dividend yield. Wells should begin to find a bottom, and we see a 3:1 Bull Bear skew.

We all recognize assets are generally cheap for a reason… the house abuts train tracks, or the company’s patents expire next year. However, in the case of Wells Fargo we have an exceptionally strong franchise trading at a significant discount due to headlines fanned by a political spectacle 40 days ahead of highly contested elections. Having been in the media, I am certain the camera will find a new pariah in short order. Meanwhile, investors should focus on the facts, figures and value at hand: Wells Fargo’s stock trades at a 2-year low, while Price to Earnings and Price to Book have fallen to 3-year lows. Wells is also now cheap versus peers. Ms. Graysek’s charts speak volumes.

How Cheap Is Cheap?
Wells Fargo Historic P/E Ratio


Let’s not overthink this. Wells Fargo is the single largest bank in the U.S. by assets. It originates one quarter of all mortgages in this country and it is exceptionally well-capitalized. The stock trades at multi-year lows. Valuation is historically cheap by several measures. Current P/E is well below the average since 2000, and Wells trades roughly even with peers currently. It usually trades at a premium. In addition, the current Price to Book of 1.17x is below the long-term average of 1.62x (per Bloomberg data). As Betsy told Morgan customers, you rarely see a bank of this caliber trade at a discount –especially Wells Fargo.

How Cheap Is Cheap?
Wells Fargo P/E vs Peers

screen-shot-2016-09-30-at-2-10-35-pmWells Fargo currently pays a $0.38 quarterly dividend and yields 3.4%. There is no danger of a dividend cut. The bank has more than enough capital to withstand any added restrictions or additional fees/penalties. Morgan Stanley and others have written publicly they believe regulators will not impose further charges. In an effort to move forward, the bank has already taken corrective measures of its own, firing 5,200 employees and announcing upper management will forgo bonuses this year. Additionally, all affected customers have been credited the full $25 cost they incurred. ATMs offer an apology on the home screen to all users. In an ugly situation, Wells Fargo is doing the right things.

Critically for investors, Wells Fargo has stopped falling on bad news… Stumpf’s second day on The Hill was a circus, Illinois and Connecticut may join California in suspending municipal underwriting with Wscreen-shot-2016-09-30-at-4-01-45-pmells for a year. When stocks stop falling on bad news, sentiment has turned and buyers are committing capital. This is the clear sign of a bottomming process and Wells Fargo will not stay cheap for long.

Buy Wells Fargo while it is still below $45. My target is $55, which equates to 13.2x 2017 earnings, Wells Fargo’s average multiple since 2000. screen-shot-2016-09-17-at-11-27-27-am

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Pets & Protein (ZTS – Issue #13.3 – 09/18/16)

Pets & Protein

#1 Global Animal Pure-Play at 10% off

  • Americans will spend $62.75B caring for pets this year
  • Total pet industry expenditures double every 12-15 years
  • China and India driving significant new demand for animal health as diets pivot to protein
  • Three companies control more than half the global market for animal related expenditures


My friend Paul is veterinarian. He breeds labs for fun, but golden retrievers are his favorite… they’re good for business. Goldens will eat just about anything if given the chance, and since surgery to remove a swallowed tennis shoe costs about $4,000, the more goldens the better. I asked him if customers ever balk, and he assured me people rarely worry about price when caring for their dogs. It’s one reason why the American Pet Products Association pegs total annual spending on pets at $62.75B… and that’s just in the U.S. Add spending globally, plus investment in herds producing food, and you realize this is a very strong industry.

Zoetis Inc. (ZTS) dominates the animal health business, with $4.8B in revenue and a global market share of 23%. It’s also one of the few animal pure-plays among top producers of medicines and vaccines, having been spun-off from Pfizer in 2012. Bankers priced the transaction to reflect a market cap of $2.2B. Today enterprise value tops $28.9B. I can think of few other companies which have increased their footprint fifteen-fold in the past four years.

The company is effectively two animal businesses in one: Companion animals (pets) and production animals (food). The pet-care business represents 43% of revenues and enjoys EBITDA margins of up to 30% –again, people are generally willing to spend a premium for their pets. The production animal business generates the other 56% of revenues and includes feed additives and parasiticides. These are administered to large herds and margins are closer to 20-25%.

fullsizerender-47As Americans reach deep into their pockets to protect pets, consumers in China and India are reaching even deeper into theirs… for food. An emerging middle class can now afford protein. Meat consumption in both countries has risen dramatically over the past fifteen years –in India it has doubled. China and India account for 36% of the world’s population (9x the U.S.) but just 22% of the world’s meat, beef and veal consumption (USDA data). Expect increased protein demand from emerging markets, and increased sales for Zoetis.

Recent Upgrade

Credit Suisse analyst Mark Wallach added Zoetis to its Recommended List just last week, and this is exactly the kind of company I have been looking to buy. In addition to a strong fundamental story, it’s completely unaffected by the all-consuming Fed Rate Debate and operates far from the preying eyes of regulators. Zoetis has no health care reform risk or election exposure. It’s a dominant player in a global business which literally touches billions of people. To quote Mr. Wallach:

As the leader in animal health, ZTS is highly levered to rebounding industry fundamentals, and earnings growth should accelerate over an improving cost and capital structure. Our focus is on under-appreciated efficiency initiatives that should drive over 737 bps in operating margin expansion in 2016 and 2017, a considerable feat for a company of its size that ensures double-digit EPS growth in 2017 and beyond.

Okay, targeting significant margin improvement cuts both ways. On the one hand, management is defining a specific catalyst for earnings improvement and this is quite positive. On the other, sucking 737 basis points of costs out of any operating business over two years creates raises a high bar for execution risk. CEO Juan Alaix ran Zoetis back when it was still part of Pfizer. He’s been at the helm for 9 years and he built the company into THE largest player in the industry. If anyone know which levers to pull, it’s him.

So in spite of being an exceptionally strong business, Zoetis is also a “Show Me” story, which I suspect explains why it trades at a discount of 10% versus peers… 21.6x the 2017 consensus estimate of $2.33/share. I should also note year-over-year earnings growth estimates of 22% clearly reflect a combination of 7% top line growth and Mr. Alaix’s cost initiative. Analysts are giving him the benefit of the doubt. So are the top five shareholders, three of whom added significantly in 2Q. T. Rowe Price bought 10.6M shares and now owns 6.3% of the company. Vanguard and Lazard each bought 1.7M shares.

Buy the Stock

Look, this is a GREAT business and Zoetis is the global leader. I’d love to buy it a little cheaper, but wouldn’t we all. Write the $50 October puts at $1.00 if you want to leg into the position, or start accumulating on down days. Its beta is 0.89 and the market has become increasingly more volatile, so you’ll have opportunities to buy in the upper 40s ahead of the election. It’s $50.50 today. screen-shot-2016-09-17-at-11-27-27-am


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New Barons of Oil (LNG – Issue #13.2 – 09/18/16)

New Barons of Oil

How Icahn & Team Beat the Regulators

  • Five hedge funds own 38% of the world’s largest LNG export operator
  • The Sabine Pass, Louisiana terminal will be able to process 9% of global LNG demand by 2020
  • Long-term supply contracts link prices of LNG at time of delivery to spot Brent prices
  • LNG was upgraded recently by Standard & Poor’s and CFO Wortley seeks IG rating longer-term


Five powerful hedge funds have figured out how to bypass position limits in oil futures, and they’ll control billions of barrels for years to come. Led by Carl Icahn, several funds have amassed a 38% stake in publicly traded Cheniere Energy, Inc. (LNG). The company is building the country’s first-ever LNG export project, and it’s hands-down the single largest global project of its kind for the foreseeable future. On the surface it looks like gas, but dig deeper and it’s about oil –more oil than anyone could ever buy in the futures market, and for many more years than contracts exist. If you’re long-term bullish energy, this is the play.

What makes Cheniere so compelling is its combination of size, first-mover advantage and oil-indexed pricing of long-term sales to global customers. The Sabine Pass facility alone will be capable of processing 9% of the global demand for LNG by 2020. 85% of its capacity over the next 20 years has already been pre-sold at spreads to the Henry Hub U.S. natural gas price, and further indexed to Brent oil as the international energy benchmark. Additional capacity will price against oil spot prices for Brent, creating an implicit call option on the price of oil over the next 20+ years. This is the kicker, and it creates far more potential upside to the long-term price of oil than the oil futures market, which caps speculative positions at 20,0000 contracts, or about $900M worth oil at $45/bbl.

How It Came Together

For decades, Congress voted to treat U.S. domestic energy resources as strategic assets and prevented their export. That changed in 2011 when the Federal Energy Regulatory Commission concluded LNG export would ultimately prove a net benefit, based on increased drilling royalties, new tax revenue and job growth. The case was further strengthened by the unique position of the U.S. as global low cost producer. Cheniere’s petition to build the first-ever LPG export facility was granted and construction began.

screen-shot-2016-09-07-at-9-36-27-amThe Sabine Pass, LA export terminal opened the first of 6 planned “trains” this summer. Each train is a self-contained facility spread over several acres which ingests natural gas via pipeline, super-cools it into liquid form, and then pipes it to holding tanks for export onto ships. Sabine Pass will be at full capacity by 2019, and 5 additional trains are currently planned for a second export terminal at Corpus Christie, TX.

Trains are financed by debt, collateralized by the physical assets, and debt repayment matches cash flow from long-term supply contacts with over a dozen global buyers. Cheniere calls them Foundation Customers, and without their commitment to buy LNG for the next 20 years at pre-determined spreads, Cheniere would not have been able to secure construction financing. Once the first seven trains are in place, which the CEO confirmed on the 3Q earnings call will be 2020, Cheniere will begin collecting $4.3B in annual fixed fees plus additional revenue on the incremental BOEs sold at spot rates.

An important comment here about Cheniere’s $19B in debt. At nearly twice the equity market cap of $10.5B and 98% of assets, it’s a lot! Cheniere is significantly more levered than any of its peers, which Kynikos Associates Founder Jim Chanos has adamantly reiterated publicly in defense of his short position. However, what distinguishes Cheniere is its matching of current liabilities to forward contracts. This is what we call a back-to-back trade, cash flow arbitrage over time. It’s why Standard & Poor’s upgraded Cheniere in Q1 to BB- from B+ and CFO michael Wortley reiterated his ongoing conversation with both rating agencies during the 3Q call. He explicitly seeks an investment grade rating at LNG’s two operating subsidiaries and intends to simply/consolidate the corporate structure. These are positives.

Money Machine

Cheniere has exported 30 cargoes to date from the newly opened train 1, and trains 2-4 will likely come online next year. On the demand side, four new markets have openedto receivscreen-shot-2016-09-17-at-11-31-27-ame cargoes in the past 14 months (Jordan, Egypt, Pakistan and Poland). As a result, earnings accelerate from -$1.68 this year to a forecast of $0.76 next year and $2.43 in 2017 –which implies a forward P/E of 18.4x.

The key here is visibility. Because Cheniere only begins the 4-year construction process to add incremental trains after securing 20-year forward supply contracts on 85% of capacity, the company is able to project multi-decade cash flow with much less expected variance than other energy related businesses. In addition, buyers include many state-owned enterprises like Electricite de France and Total, so default is not an issue.

While predictable cash flow is always appealing, the growth-minded hedge funds atop Cheinere’s list of shareholders are looking for far more than predictability, and they’ll get it. Cheniere sells 85% of capacity at a pricing formula which locks in a spread of 15% over the Henry Hub spot price for natural gas (plus additional charges for transportation, handling and storage) AND THEN INDEXES THE FINAL SALE PRICE TO SPOT MARKET PRICE OF BRENT OIL. It does so because Brent is the international energy benchmark, both for barrels of oil and gas-rchenelated barrels of oil equivalent (BOE). As Brent rises, Cheniere and its hedge fund shareholders make more money, especially on the 15% of capacity left unhedged and therefore able to rise with market prices.

Owning shares of Cheniere is like being long a call option on the future price of oil. The stock tracks closely with Brent, and cash flow from 20-year contracts provides sufficient cash flow to temper the downside. Additionally, long term investors recognize oil may be $45 now, but it won’t stay here indefinitely. The Baker Hughes Index of rigs actively drilling for new oil has fallen from 2,000 two years ago to 497 today. Stop drilling for new oil and your current supply runs out… prices rise. This is one of the reasons why forward Brent oil is well above today’s spot prices. The December 2019 contract costs $55.75 currently, 16% more than the current spot price.

Here’s the other key point: the ICE position limit for Brent is 20,000 contracts, which equate to less than $1B worth of oil at today’s prices –about one quarter the market value of the stock position held by the five hedge funds. True, so-called bona fide hedgers can get exemptions above position limits, but if you’re simply a large investor with a view, the futures market is too small. Icahn and his fellow investors in Cheniere have effectively gone around the position limits and created huge potential upside through Cheneiere’s exposure to oil-linked contracts. It’s the ultimate operating leverage play.

How WE Trade It

I believe Cheniere will develop into a core holding. It offers cash flow growth, earnings visibility, access to a global business with high barriers of entry and a 20-year call option on higher oil prices.

  1. Buy the stock now
  2. Sell covered call options to generate income, so we get “paid while we wait”
  3. Write out-of-the-money put options opportunistically (ie on declines) to capture additional premium and/or increase position size

For example, buy the stock at $45.00 to establish a position.

If I sell an October 50 call at $0.60 and an October 40 put at $0.70 I capture a total of $1.30 in premium for the next 42 days. This generates a 2.89% (25% annualized) if the stock stays between $40 and $50 through expiration and effectively lowers my cost basis on the original purchase to $43.70.

What if the sock trades through the strikes you ask? I will potentially own more shares under $40, or I will be called away at a profit above $50. I could also cover the options and simply hold the stock. Remember, selling options works in your favor over time, since every day they are worth less. Also, by creating a wide price bracket with out-of-the-money strikes, you’re building in a generous cushion. In this case, a 22% cushion over 42 days (50-40/45). screen-shot-2016-09-17-at-11-27-27-am



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Sleep No More (Issue #13.1 – 09/18/16)

Sleep No More

Picks & Pans Into Yearend

  • The recent 3% selloff ends what had been the least volatile 4 week period since May 2014
  • Probability of a September rate hike has gone from 18% to 48% and back to 18% in 4 weeks
  • 84% of hedge funds tracked by Bloomberg have received redemption notices this year
  • Bullseye winners outnumber losers more than two to one (70% vs 30%)

August was perfect. I rode a Citibike to the office every morning and spent days admiring an exceptionally well-behaved portfolio. Longs worked higher and shorts edged lower. It was all exactly as it’s supposed to be. Then came Labor Day. In the span of 36 hours we learned investors are yanking money from hedge funds at the highest rate since 2009, U.S. economic indicators have taken a noticeable turn lower and no one has a clue about interest rates… especially The Fed! Sleep no more, volatility has returned with a vengeance and we have to weigh thoughtfully what we want to own into yearend.

Step One is to take inventory and identify what’s working, as well as what’s not. I have been publishing since the Spring, and my track record thus far is positive by a factor of 2:1. Puts on both gold miners and the S&P 500 Index have been my most profitable positions. Several specific stock and bond recommendations have also performed well. Most of the negative returns stem from ideas only recently discussed, which means they’ve taken it on the chin in September. Here’s a snapshot.








Before addressing the portfolio as a whole, let me first acknowledge the bright red nasty at the bottom of the list. LendingTree, Inc. (TREE) originates, processes and approves loans online. It operates on both a direct and agency basis, making loans for its own account as well as providing a platform for other banks to compete for customers (as Priceline and Orbitz do in the travel industry.) I believe regulators will ultimately take issue with how TREE presents borrowers to banks as “product.” In addition, its clearinghouse function may prove redundant long-term for large banks like J.P. Morgan which already have strong online solutions. That said, analysts hail it as a “new economy” stock and it’s a very hard short. No risk manager worth her salt would ever tolerate a 32% loss. Cover it.

All of my write-ups are available for your reference on the Past Issues tab, so you can easily access them for detailed analysis. What follows is an overview of important themes playing out right now, and how to position accordingly. I group positions thematically an offer essential charts and/or data for illustration.



The appeal of banks as a long is three-fold: Valuation, Rising Rates (eventually) andscreen-shot-2016-09-17-at-11-10-09-am they have been so reviled for so long. Morgan Stanley’s analyst team sums it up this way: While the group has been a “bellyflop” to own for the first half of year, Financials may pose the best opportunity in the second half of 2016. The bull case is predicated on low ownership, a fundamental expectation of improving revenue comps and still aggressive focus on expenses. Also, banks and asset managers which missed revenue estimates during the quarter actually had positive returns one week later, outperforming stocks in other sectors that missed revenue expectations. That itself is a hallmark sign of bottoming. Morgan Stanly overweight names include JP Morgan (JPM) and Bank of America (BAC). My own top picks are BofI Holding, Inc. (BOFI) and Bank of the Ozarks (OZRK). For more click 

Data Mining

IDC values the market for Big Data at $122B, which provides ample reason why the nine companies I profiled in February have since rallied over 41%. According to Bloomberg Senior Software Analyst Anurag Rana, “The ability of cloud application vendors to provide advanced analytics on their core products may become the single biggest distinguishing factor in the year ahead. Machine learning and other advanced data analysis methodologies are becoming increasingly important for clients to better understand their user-base. Rising use of Internet of Things (IoT) products will also fuel demand for analytics. Pure-play visualization vendors will likely expand their product portfolio as competition increases.” Data is everything right now, from Target’s Cartwheel app which tracks you in the store to Honeywell’s decision to hire hundreds of software engineers. Own this theme.


I admit I LOVE taking about oil, both because I began my career trading jet fuel ascreen-shot-2016-09-17-at-11-10-20-amt Louis Dreyfus Energy and because oil so integral to the global economy. The essential thesis behind owning energy NOW is that so much production has been taken offline we are not finding replacement barrels to satisfy future demand –the Baker Hughes Index of active
drilling rigs has fallen 75% since 2014. While the International Energy Agency calls for the current supply overhang to persist into 2017, lack of activity is setting the stage for the next rally. I want to buy best-in-breed assets in anticipation. As I have noted on multiple occasions, EOG Resources, Inc. (EOG) and Concho Resources, Inc. (CXO) are the only two exploration and production companies which consistently fund new drilling projects with cash flow from existing wells. They are the two to own.

Health Care

The election has turned health care into a political punching bag as candidates vie for votes. Each side has promised to defend “average Americans” from rising costs and inefficiencies. However I suspect the bark will likely prove worse than the bite. More importantly, the demand side of health care is staggering. U.S. health spending in 2016 will exceed $10k per person for the first time, and total health care expenditures at 17.8% of GDP will rise to 20% by 2025. The surge is driven largely by three million baby boomers who will reach retirement every year for the next 25 years and require 1.6M new care providers by 2020 according to the National Council on Aging (NCOA). This is obviously a macro call so the easiest way to get exposure is through exchange traded funds, specifically the SPDR S&P Biotech ETF (XBI) and the SPDR S&P Pharmaceutical ETF (XBH).

Gold Miners

Sometimes a picture is worth a thousand words. I showed this chart in July to illustrate how miners have become totally detached from the price of gold. They still are. Stay Short. Btw, my favorite poster child for overextended miners has fallen 22% from its high –Coeur Mining, Inc. (CDE). If you didn’t short it then, there’s still time. It’s up 401% YTD.



On my recent podcast I described REITs as Real Estate Investment Traps. Here’s the negative thesis in a nutshell. First, higher rates imply higher borrowing costs for REITs, which squeezes margins and lowers cash flow available to fund dividends. Second, many current project were financed at historically low cap rates of 3-4%, meaning developers will have to own properties at 100% occupancy for 25-30 years to recoup their initial investments. This is not a prudent business model. Third, e-commerce now accounts for 8.7% of total retail sales, which means mall REITs in particular are losing their core customers. Macy’s, Sears and even Target have announced store closings recently. This does not bode well. Sadly, individual investors have plowed more money into the sector this year than any other. Do not own this group. Short it via General Growth Properties (GGP), hotel operators which pay rents to REITs Hyatt Hotels (H), Marriott International (MAR), Wyndham Worldwide Corp (WYN) and the Vanguard REIT ETF (VNQ).


Boring staples became one of the darling sectors of the market a couple of years ago once investors realized the Fed was going to keep rates lower for far longer than anyone expected. In a low growth, low rate environment, their stable cash flows and dividends started to look pretty good, even if band-aids and bleach weren’t exactly growth categories. The group attracted so much capital that the shear inflow pushed valuations to 25-30 times earnings, which also meant that the whole reason to own them (ie 3% dividend yields) got squeezed down to below 2%. Sorry, but that math doesn’t work. I identified a handful of names that have no business trading at current valuations. Church & Dwight (CHD) is particularly egregious at 27.4 times this year’s earnings, with a dividend of just 1.5%. Baking soda doesn’t deserve that much affection. screen-shot-2016-09-17-at-11-27-27-am

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Back From Siberia (XLF – Issue #12.3 – 09/04/16)

Home From Siberia
13 Banks to Buy Now

  • The KBW Bank Index has rallied 20% since June
  • Banks are still the cheapest group in the S&P 500 based on Price to Earnings and Price to Book
  • Brokerage firms beginning to turn positive on banking sector for first time in several years
  • Bloomberg Intelligence estimates 8% rise in net interest income if Fed Funds increase 100 bps


I love the geeky stuff Bloomberg’s analysts come up with, especially when it reveals something I hadn’t considered myself. Buried deep inside the new Bloomberg Intelligence application I stumbled upon a data-driven analysis of what happens to bank earnings as interest rates rise. BRILLIANT. That’s the whole thing right now. Admittedly, only money center banks and larger regionals provided the guidance necessary to drive the study, but suffice to say their sample suggests net interest income will increase 8% on average if the Fed raises interest rates 100 basis points. No wonder banks have popped 20% since June, investors finally have a reason to own them –especially with rock bottom valuations relative to the market. The question is, which ones should we buy?

Screen Shot 2016-09-01 at 2.37.28 PMBanks have been dead money for so long. With home ownership still at a 40-year low of 63%, their largest engine of growth has been sputtering. Bloomberg divides the S&P 500 into 19 super-sectors and banks have ranked dead last this year both for earnings revisions and upside potential relative to current target prices. This is because there has been little reason to get excited over the past five years. Bank revenue growth and return on invested capital since 2011 have ranked 17 and 15 respectively. Not surprisingly stock returns too, have been down –though that has begun to change. Banks appear to have finally come home from their exile in Siberia.

Banks Anticipating Rate Hikes AND Outperforming

I admit, buying banks solely because the Fed will begin raising rates seems one-dimensional, and yet my inbox has been inundated with notes/questions/commentaries about the banks being cheap and how the macro environment has begun to shift. Here’s a sample from the past week alone:

Morgan Stanley
While the group has been a “bellyflop” to own for the first half of year, Financials may pose the best opportunity in the second half of 2016. The bull case is predicated on low ownership, a fundamental expectation of improving revenue comps and still aggressive focus on expenses. Also, banks and asset managers which missed revenue estimates during the quarter actually had positive returns one week later, outperforming stocks in other sectors that missed revenue expectations. That itself is a hallmark sign of bottoming. Morgan Stanly overweight names include JP Morgan (JPM) and Bank of America (BAC).

Strategas Research
The recent leadership from the Bank stocks is noteworthy, particularly given the persistent shape (flattening) of the curve. Bellwethers like JPMorgan (JPM) are acting well, and even the European Banks have bounced from small bases. Our hunch is the improved performance of the Banks and the relative weakness from Utilities may be foreshadowing at least a modest move higher in yields.

Bloomberg Intelligence
Loan growth has remained strong at regional banks, rising to 8% in 2Q… the past 12 months have been aided by residential mortgages, credit cards and other consumer lending. Median commercial and industrial loan growth has been stable sequentially at 7%.

The call from strategists is two-fold: Lending is improving so volumes are rising, and rates are going up so margins will expand. Coupled with the cheapest valuations of all 19 S&P 500 super sectors, you can understand why animal spirits are beginning to stir. Like E&P companies earlier in the year after oil started to re-inflate, investors smell opportunity and they have already begun to buy.

I see three ways to get exposure:

  1. Go total macro and buy the exchange traded fund for money center banks, the Financial Select Sector SPDR Fund (XLF)
  2. Focus more on the large regionals with lower exposure to capital markets via the SPDR S&P Regional Banking ETF (KRE)
  3. Drill down and find the highest quality banks within the S&P 1500 Index and create your own portfolio, recognizing premium assets are generally not be the cheapest.

The two ETFs are perfectly acceptable ways to express a macro view, and they will certainly provide exposure to some of the less expensive companies. If I’m bottom fishing, this is he way to go. As for the quality option, I’ll look past high multiples of earnings and book value, focusing instead on superior operating metrics.

Here’s how I constructed my screen of the 97 banks in the S&P 1500 Index:

  • Net Interest Margins are greater than 3.44% (the current average). Note JPM and BAC are below 2.3%. Ugh. Both banks are also in the XLF, which is why I’d rather sniff out my own handful of names.
  • Net Interest Income and Total Assets are both rising at least 10%, implying a bank is adding healthy loans to its portfolio. (If assets were rising but NII weren’t, I’d be concerned.)
  • Earnings are rising at least 10%
  • Non-performing loans equate to less than 1% of total assets. The national average is 1.9%.

This criteria yields a total of 13 banks. While not cheap at an average price to book multiple of 1.9x and a forward earnings multiple of 14.4x, these are the superior names I want to own. They are up an average of 9.7% YTD, roughly in line with the S&P 500 Index. I’ve highlighted standout metrics in yellow.

Note: I’m happy to see Bank of the Ozarks made the cut. CEO George Gleason just closed his most recent acquisition and I wrote this up may in April before Bullseye’s official launch Also of note, BofI Holdings appeared on my recent 10/10 Screen (10% growth under 10x earnings) and has since been moving up! 

Quality Metrics = Quality Banks
Screen Shot 2016-09-02 at 11.51.40 AM

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Cash Cow (Issue #12.2 – 09/04/16)

Cash Cow
4 Stellar Income Funds

  • Income funds attract more capital than Value for the first time ever
  • 9 ETFs have attracted the lions’s share of new money flowing into the asset class
  • REITs, Utilities and Energy rank highest among sectors for both dividend yield and net inflows
  • Yellen’s Jackson Hole mention of sub-2% inflation for several years extends yield grab

BlackRock CEO Larry Fink must absolutely love Fed Chair Janet Yellen. Her classic Greenspan doublespeak is very good for his top-ranked ETF business. While telling us “The case for rate increases has improved in recent months,” she also made clear in her Jackson Hole speech last week inflation will “stay below 2% for several years.” In other words, the economy is improving, but it’s hardly a runaway train. So forget about trying to pick growth stocks, just park your money in steady-eddie income funds. BlackRock’s iShares business now accounts for 23.5% of the firm’s assets under management, and with Yellen’s implicit endorsement for the passive money crowd, I could imaging Mr. Fink embracing a new fall ad campaign… #StashYourCash followed by #ThankYouJanet.

To be clear, Chair Yellen isn’t really saying anything new. The dual mantra of Low Rates and Sub-par Growth has created a stampede into income funds this year which gives the Houston Rodeo a run for its money. The total amount of capital flowing into income-related ETFs has outpaced flows into value-focused funds this year for the first time ever. Instead of betting on capital appreciation tomorrow, investors are opting for cash returns today.

Cash Is King

What’s particularly revealing from Bloomberg’s data is the lack of interest in “Quality” or “Size” as a determinant for what to buy. This is presumably because large, AAA-rated companies currently trade at premium valuations, which implies they generally yield less than 2% and their bonds offer piddles in the way of return. By contrast, the junk bond ETF JNK has seen shares outstanding rise 20% this year, and the emerging markets ETF EEM has seen a 28% increase in assets just since June. Investors are eschewing all definitions of safety in search of yield.

You can also see this move farther out the risk spectrum when comparing fund flows by sector. ETFs which invest in REITs have attracted $7.1B in capital this year, by far the largest net inflow. Never mind developers are paying record low 3 to 4% cap rates, pushing breakeven holding periods on commercial properties to 30 years. As long as buildings generate cash flow, banks will fund the debt and pension funds will buy the equity… their underfunded obligations mean they need cash NOW. Utilities too have become the darlings of income investors this year. Again, never mind they trade at 18 times forward earnings and require regulatory approval to raise rates even 1%. Investors want income, and income hard to find.

Chasing Income
ETF Flows by Sector YTD
Screen Shot 2016-09-01 at 2.46.00 PM

You can see the clear correlation between higher yield (purple line and left-hand scale) and where the money is flowing (blue bars and right-hand scale). As for specific funds these nine have grabbed the lion’s share of income seeking capital.

Income Stampede
The Herd’s Favorite ETFs
Screen Shot 2016-09-01 at 2.45.29 PM

I hate crowded trades, but I also recognize Chair Yellen is telling us to expect relatively low rates for the next several years, which means income will remain crucial to generating total return. Like it or not, we have to own some of these funds, or at least the stocks they hold in position. I offer four suggestions:

1. SPDR Select Dividend ETF (SDY)
Of the ETFs cited above, I particularly like the methodology of the SPDR Select Dividend ETF (SDY). It choses the 60 highest yielding stocks in the S&P 1500 Index which have also raised dividends consistently every year for 20 years. The fund holds a total of 108 equities across multiple sectors. Indicated yield (next dividend annualized) is 2.37%, but each December it announces a capital gain which bumps yield significantly –figure 5.4% this year based on last year’s payout. In addition, Bloomberg currently forecasts an increase in the September dividend to $0.57, 12% above the June level.

2. JPMorgan Alerian MLP Fund (AMJ)
I reiterate my fondness for the JPMorgan Alerian MLP Fund (AMJ), which invests in the toll-collecting components of energy infrastructure and pays a generous 6.5% dividend. I just wrote it up last at the beginning of August so I should probably “cool it” on this theme, but I really do believe it makes excellent sense. As long as energy products are moving (which is always) pipeline companies make money and distribute cash flow to investors. In a related vain, one of our subscribers emailed me the following response after I wrote the AMJ piece: In your search for oil plays look at The Cushing Total Return Fund (SRV), a closed end fund (no paperwork) of MLPs. It’s all pipelines selling at a 15% discount to NAV and yielding 8-9%. The fund sold at a premium in the good old days, though it’s thin. Thanks EH.

3. Vanguard’sWellington Fund (VWELX)
My good friend and former guest from Bloomberg Television, Dan Weiner also happens to be THE GURU for all things Vanguard. His monthly Independent Advisor for Vanguard Investors is followed by tens of thousands. He describes the flagship Wellington Fund (VWELX) as “The grand-daddy of the mutual fund industry and it’s still going strong… run by a pair of Wellington Management veterans in very steady fashion.” The managers invest about two-thirds of capital in high-quality blue chips and the balance in a combination of “top-notch” government and corporate bonds. The current indicated yield is 2.59%, but that will likely rise to about 6% when the annual year-end distribution is announced in December. This is a fund for the buy and hold crowd. It charges a management fee of 0.24% and has expense ratio of 0.26%.

4. InfraCap Active MLP ETF (AMZA)
If you feel like a walk on the wild side, check out the “impossibly” high yielding InfraCap Active MLP ETF (AMZA). The operative word is here active. It currently yields 18.06%, in spite of holding 34 MLPs which yield a maximum of 10.57%. The fund does not use leverage. So how do they do it you ask? By writing options, LOTS of options. Most are covered calls, meaning there is a long position match against the short call. But my recent podcast cast guest, Investor Media Managing Editor Kyle Woodley did some digging and unearthed a spreadsheet of current holdings. To be clear, there’s nothing wrong with writing out-of-the-money options which go to zero in order to capture premium. Just recognize it’s all well until it isn’t. I actually kinda like this strategy, but I may have to just watch it for a while before I dive in.

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Lunch Is For Wimps (#12.1 – 9/4/16)

Lunch Is for Wimps
3 Pending Buyouts as Cash Alternative

  • M&A deal spreads typically trade 3-4 times the “risk-free rate” of the U.S. 10-yr Treasury Note
  • Several large cash-only transactions trade at annualized spreads above 5%
  • Global M&A averaging 3,000 transactions/month offer multiple arbitrage opportunities
  • Quality transactions with high probability of completion present an alternative to low yielding short-term debt

”No interest” is one of those memorable expressions from Wall Street’s go-go years of the late 80s. With two dismissive words, Masters of the Universe like Gordon Gekko could shoo away block-trading brokers and go back to their screens without missing a beat. Funny I actually uttered them at my neighborhood bank last week when a teller offered me a 91-day certificate of deposit at 0.15%. No interest indeed. Taking me literally, he suggested I could double the return to 0.30% by going out to 15 months. I paused for a moment and realized I’d need to wait four years to earn a full percent… no interest! I may not be Gordon Gekko, but I work too hard to watch my cash do nothing. CDs are for wimps.

Mr. Gekko was known in his day as a risk arbitrager, Hollywood’s version of real-life deal junkies like Boesky and Icahn. The term derives from exploiting pricing differentials for announced takeover deals. When an acquirer announces its intention to purchase another company in an M&A transaction, arbitragers typically buy the target and sell the acquirer in a ratio which reflects the terms of the deal. If for example A is buying B, offering to pay 2 shares of its own stock for every share of B, arbitragers would buy one B share and sell two A shares. The opportunity to profit arises because B will generally not trade exactly at 2x A, but instead at a slight discount. This so-called “deal spread” reflects uncertainty of obtaining all necessary regulatory approvals, shareholder support and time to completion. Even the simplest deals often require several months, and deal spreads narrow over time as the two parties come closer to completion.


Deal Spreads and CDs


Deal spreads and CDs actually have more in common than you might think. While some M&A transactions face significant regulatory hurdles, like Anthem’s current bid for Cigna, most announced deals are ultimately completeM&Ad. Traders price spreads between 3-4 times the benchmark risk-free rate of return, which equates to an annualized rate of 4-6% with the 10-yr Treasury at 1.5%. So for the professional investment manger eager to earn a return on cash, risk arbitrage presents an alternative to holding short-term assets like commercial paper, certificates of deposit, 6-month T-bills and near-dated corporate bonds. It doesn’t pay the 6-8% returns available on junk bonds, then again it sure beats the negative rates in Europe and Japan. For global asset managers in search of yield, solid M&A transactions with a high probability of closing present a legitimate solution. In addition, healthy M&A volumes present multiple choices.

Keep It Simple


Most large money-center banks and diversified hedge funds include risk arbitrage within their suite of services, though often times it’s viewed as its own designated asset class rather than as a cash alternative. This is unfortunate. By focusing on plain vanilla, cash-only transactions with a high degree of probability for completion, smaller asset mangers could shift a portion of their cash equivalent holdings to select M&A transactions and earn additional return for clients at reasonable incremental risk. I offer three specific examples of cash-only deals which offer annualized returns averaging 5.03%.

(Note: Since there is no stock component to a cash-only bid, the deal spread is simply the difference between the current stock price of the target and announced/agreed upon takeout price. These are truly plain vanilla transactions. In addition, these three have a high probability of completion.)

1. Microsoft / LinkedIn (MSFT / LNKD)

LNKD currently trades at $192.05, a discount of $3.95, or 2.02% to the takeout price. As the deal is expected to close on or before 12/31/16, this equates to an annualized return of 6.03% Bloomberg calculates a 94.47% probability of a successful deal closing.

On June 13 MSFT announced an all-cash acquisition for LNKD at $196.00 per share. The total deal value is $24.3B, which represents the largest technology transaction YTD. At 51x estimated earnings, it is also the largest multiple of earnings ever paid in the sector for deals greater than $5B, per Bloomberg data. As a result, there is very low likelihood of dissident LNKD shareholders asking for a higher price, or additional bidders derailing completion. This is a very high quality transaction.

  • The boards and shareholders of both companies have approved the transaction.
  • Miscrosoft has already fully funded the purchase price with a combination of cash and bonds.
  • High quality advisors on both sides. Allen & Company is advising LNKD, Morgan Stanley is advising Microsoft. White & Case is representing LNKD legally, Davis Polk is representing MSFT. Deloitte serves as the accountant to both companies.
  • Standard Hart-Scott-Rodino approval from DoJ is pending, though expected. Additional information requested by government lawyers is the only potential snag to timing, though LNKD has no competitor and MSFT is not in the business so anti-trust issues seem unlikely.

2. Danone / WhiteWave (BN FP / WWAV)

WhiteWave Foods currently trades at $55.40, a discount of $0.85, or 1.50% to the takeout price. As the deal is expected to close on or before 12/31/16, this equates to an annualized return of 4.50%. Bloomberg calculates a 91.96% probability of a successful deal closing.

Yogurt maker Danone of France announced its second largest-ever acquisition on July 7, 2016, offering $56.50 for all outstanding shares of specialty food producer WhiteWave Foods Company. Its products include LandOLakes butter and Silk brand almond milk. WhiteWave’s organic growth of 10% is double that of Danone, making it a highly attractive target worthy of the 23% deal premium paid by Danone.

  • The boards of both companies have approved the transaction.
  • WhiteWave shareholders will vote 10/26. Additional approvals are required from the European Commission (10/24) and DoJ under HSR (9/4)
  • Financing is already arranged using debt.
  • High quality advisors (Goldman Sachs for WWAV, Lazard for Danone).

3. Pfizer / Medivation (PFE / MDVN)

Medivation currently trades at $80.25, a discount of $1.25, or 1.53% to the takeout price. As the deal is expected to close on or before 12/31/16, this equates to an annualized return of 4.59%. Bloomberg calculates a 92.80% probability of a successful deal closing.

Medivation is truly the Belle of the Ball, having first received a bid of $58/share from Sanofi in April, and having caught the eyes of multiple rumored suitors along the way (AstraZeneca, Celgene and Gilead). Alas, the San Francisco-based biomedical company looked past flashy Europeans and agreed just last week to tie the knot with New York’s own Pfizer. Given the deal’s valuation multiple of 62 times earnings and 15 times sales, cash-strapped Europeans might not have been able to afford fair Medivation anyway. Pfizer’s pending patent expirations make Medivation’s triple patent-protected treatment for prostate cancer far too tempting to resist, and it paid quite a premium to make the magic happen.

  • The boards of both companies have approved this transaction.
  • Additional approvals are required by DoJ under HSR (10/20), though there is no drug overlap.
  • PFE will fund the acquisition with debt, raising its Net Debt to EBITDA from 1.3x to 2.0x, which is still less than the average for the S&P 500.
  • Evercore and J.P. Morgan are advising Medivation. Guggenheim and Centerview are advising Pfizer.
  • As this deal was announced fewer than 20 days ago, Bloomberg cannot yet calculate probability of closure –though the tightness of the spread indicates very strong likelihood of completion on or before 12/31.

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