Author: jolvera

The Last Shall Be First

21 Shorts to Avoid

• Hard-to-borrow shorts outperform broad market nearly three to one in February
• Nearly 10% of large and mid-cap stocks nearing hard-to-borrow threshold
• Short Interest as a percentage of float hits a post-crisis high
• Heavily shorted stocks up significantly YTD

The Head of Block Trading had lost seven figures in several minutes. He was desperate, in disbelief and almost inhuman as he hovered in place, staring into his screen. We were new to the desk, new to Wall Street and totally petrified. All we wanted to do was get out of his way. Hundreds of traders and the room had gone silent. “I’m am getting my face RIPPED OFF.” And then it got worse.

Short squeezes are highly unpleasant. You watch prices accelerate and realize the only way to make the pain go away is to buy. Every purchase is higher, and then you begin to think everyone knows. You’re not paranoid of course, just convinced you’ve been ratted out and now everyone’s ganging up on you… squeeeeezing.

To the uninitiated, selling borrowed shares on the assumption you’ll buy them back later at a lower price probably sounds slightly twisted. In fact, it’s quite common. Like our Head of Trading who was simply taking the other side of a customer’s purchase and rounding out a large order, going short is a part of every day market making. For a portfolio manager with net long exposure, shorting rebalances the overall risk profile towards neutral. In theory it reduces risk.

We say “in theory” because shorts have taken investors for quite a ride recently. The top 10 percent MOST shorted stocks in the S&P 1500 Index rallied 27.70% from the February low through early March, nearly three times the rise of the broader market. Meanwhile, the least shorted stocks –which by default we could call the least hated stocks–lagged the market and rallied just 8.80%. Strange times indeed.

Most Pain…Most Gain

S&P 1500 sorted by Short Interest

This action is incredibly significant. So-called “rip your face off rallies” are common in heavily shorted stocks which have been placed on the Hard to Borrow List, but rare for such a large group of stocks simultaneously. The extreme price move perfectly illustrates the concept of why crowded trades are best avoided, unless of course you’ve identified the imbalance in advance and taken the other side. Again, look at the data above and focus on the top row. The most heavily shorted, most hated stocks in America rose 27.70% in one month.

What’s happening here? First of all, recognize shorts as an asset class are on the rise. The bull market has entered its 84th month, well above the average run of 59 months for post WWII bull markets, and The Fed has begun turning off the spigot of excess liquidity, in spite of GDP growth which still lags the +3% target. Additionally, the S&P 500 Index trades at approximately 16.5 times forward earnings, towards the higher end of the historic 14-17x sweet spot. So you can understand why portfolio managers are eager for ballast against their longs. Two primary measures of short activity have increased steadily since the financials crisis:

1. Short Interest as a Percentage of Float Divide number of shares shorted by total shares freely trading in the market to express the level of short activity in relative terms. Currently 4.35%, this ratio is the highest since 2008, having bottomed in 2011 at 3.11%. That’s an increase of 40% in five years (white line below).

2. Short Interest Ratio, or Days to Cover Divide short interest by average daily trading volume to determine how many days of typical activity are required to eliminate the overall short position. Note: recent declines reflects 15-20% higher daily trading volume, not lower gross short activity.

Shorts on the Rise

SI as % Float hits 5yr High

So we have a general backdrop where shorting is on the rise, opening the door to sudden updrafts which create artificial rallies and obscure fundamentals. 88 of the 900 largest public companies traded in the U.S. have SI to Float ratios at or above the hard-to-borrow threshold. Investors MUST consider the short landscape for a given stock before initiating a position, even if they are going long.

From my days as an options trader calling Bear Stearns’ Stock Loan Desk in search of stock to short against customer buy writes, the general Rule of Thumb is any SI/Float Ratio above 11% equals Danger Zone. If 11% or more of the float is shorted, then the stock by definition is Hard to Borrow and subject to buy-ins by margin clerks who must balance accounts by end of business. If back office clerks are in there buying and you are short, you have a GIANT problem. They will keep buying until the position is covered. They will not ask questions and they do not care. They are they gorilla baggage handlers from the old Samsonite commercials.

In the interest of avoiding said beasts, we’ve established some basic ground rules and complied a list of stocks which we will absolutely not short. First, resist shorting a stock priced under $10 and NEVER under $5. At that point you’ve already missed it and they’ll rip it in your face. Chesapeake Energy (CHK) comes to mind as a recent example. Second, avoid small caps in general. They are less liquid and harder to borrow. More fertile ground exists elsewhere. Third, steer clear of stocks which trade fewer than 100k shares per day. They are too unpredictable.

Now let’s screen for large and mid-sized companies which look squeezable. We choose our words carefully here because 1. We will definitely not short them 2. We might even buy them opportunistically if we smell smoke (see paragraph one). Our list includes stocks in the S&P 500 and 400 Indicies whose short interest as a percentage of float exceeds 20%, and where five or more days would be required to cover all outstanding short positions. We also present sales data to help explain why shorting is elevated (sales are generally falling while P/E is high) and returns YTD to show why crowded shorts are dangerous (stocks are generally up).

What to NOT to Short

Values as of March 10, 2016

Anchors Aweigh

One Fleet to Own Now

• High quality shipping assets are trading at significant discounts to net asset value (NAV)
• China LPG imports up sixfold since 2008 are forecast to rise again in 2016/7
• Niche operators earning profits now are highly levered to potential rate increases
• Maritime stock valuations tracking commodity prices will recalibrate to shipping volumes

We’ve just identified the Perfect Storm, and we like what we see. StealthGas is a Greekbased operator small-sized tankers transporting Liquified Petroleum Gas (LPG). It embodies everything investors have been desperately trying to avoid for the past 12-18 months: Uncertainty in Greece; Price Implosion in Energy; Oversupply in Shipping. So why are we intrigued? Price. The stock trades at a fraction of net asset value. In addition, it has lots of cash, very little debt, a new fleet with dominant market share. One more point: It’s making money even now, at the lowest shipping rates in decades.

StealthGas is a balance sheet story with a cash flow cushion. Assets comprise cash of $100M and a fleet valued at $1.05B. Its 53 ultra-high quality, Japanese-made LPG carriers have an average age of 8.8 years. The fleet is almost fully booked, operating at 93% of capacity, and last year the company generated nearly $50M in EBITDA. Liabilities as of 12/31 totaled $455M, including $75M short-term debt and $347M long-term debt. Debt is privately held by international lenders in the form of loans at an average of +200bp over LIBOR for terms of 7-15 years. Leverage (net debt to assets) is 35%, half the industry average and likely to decline through 2018 as the company retires a portion of its current loans. Bottom line, StealthGas owns high quality assets funded with low comparative levels of debt.

Compelling Value

Key Metrics as of 12/31 (millions)

We interviewed CEO Harry Vafias mid-March at the NASDAQ market site. To say he is exasperated by the current price is an understatement. While he concedes all shipping stocks have suffered with oil prices, especially StealthGas as a Greek domiciled enterprise, he thinks the discount is extreme. “Let me stress how cheap our stock is, how strong our balance sheet is. We have very little debt and lots of cash. We are trading at less than a quarter of NAV. Someone should buy us.”

Let’s indulge that last comment for a moment and imagine that someone should be us. Current enterprise value is $457M, which includes equity and debt less cash. Assuming we paid a 20% premium to equity holders as a sort kiss to the Gods (this is a Greek company, after all) our total purchase price would rise to $484M. In return, we’d be getting 53 virtually new ships worth $1.05B and generating an estimated $69M in cashflow this year. At this point we could either:

a. Net $251M by liquidating the company, which entails selling the fleet at say a 30% discount to market value and then netting proceeds against the purchase price (1.05*0.70 – 484 = $251M) to generate a Return on Equity of 52% (251 / 484)

b. Earn $25M annually by privatizing StealthGas in an LBO, financed by putting up a portion of the fleet as collateral and using cash flow to support debt payments. If we apply the same 30% haircut to the fleet’s market value, we’d need to post roughly 2/3 of the fleet as collateral against the purchase price (484 * 1.3 = $629M). If this were financed with debt at 7%, debt service would total $44M (629 * 0.07), which is easily covered by 2016 estimated cashflow of $69M. Pretax operating profit would be $25M (69 – 44).

To check our math and get a second opinion, we spoke with Jefferies’ I.I. ranked shipping analyst Doug Mavrinac. For starters, he rates the stock a buy with a $7 price target, suggesting it’s 50% undervalued at current prices. He shared several other key perspectives. First, he notes StealthGas is making money at the bottom of the rates cycle, which should provide considerable operating leverage if rates begin to rise. In fact, Mr. Vafias told us a sustained increase of $1,000 in the current day rate of $7,000 would add $20M to cashflow this year. Second, Doug argues maritime shipping stocks should trade on the volumes of the materials they transport, NOT the prices of those materials… and volumes are up.

Liquified petroleum gas (LPG) shipments from the Mideast to China have been rising steadily. This is where two-thirds of StealthGas vessels are booked on term charter, and why the company enjoys a 93% operating rate. Since 2008, China’s imports have increased sixfold, as rising household wealth has enabled more Chinese to purchase cooktops and stoves. Globally, Doug forecasts global LPG trade will grow 15-16% in 2016 and 10-11% in 2017. This is very good for StealthGas.

China Driving Demand for Tonnage

Imports of LPG + Hydrocarbons (000 tons)

Critically, StealthGas operates vessels in the smallest class of LPG carriers (3,000-8,000 cubic meters). This is a distinguishing advantage over competitors, whose larger vessels cannot access the many smaller ports which supply secondary and tertiary Asian markets. Additionally, with fewer smaller vessels on the water currently and fewer new build deliveries expected in 2016 (11% vs 39% overall) smaller vessel day rates are significantly less volatile than those for larger vessels. Doug believes this combination of fundamentals creates divergences within shipping asset classes and positions StealthGas as the one to own.

Ultimately, the maritime shipping industry is fairly easy to understand. Operators fund vessel purchases with debt, servicing coupon payments with cash flow earned from transporting material with predictable regularity. Eventually, bonds come due and vessels are either recapitalized or sold. Proceeds fund purchases of new vessels and the cycle recommences. The opportunity in StealthGas currently is equally straightforward: A stock valuation at 19% of net asset value is simply too cheap for a market share leader whose vessels are nearly fully booked, generating ample cash flow to service low levels of debt and produce profits for shareholders.

 StealthGas: Too Cheap to Ignore

March 2016 (Bloomberg data)

Keep It Simple Stupid

Seven IT Companies Transforming Engagement

• Mobile data volume has risen eightfold since 2012 and will accelerate into 2017
• Data overload is upending the C-Suite and creating bottlenecks across enterprises
• 45% of US companies struggle with legacy systems and 36% with change management
• Agility and Artificial Intelligence are redefining customer interaction

Amtrak’s Acela speeds the suit-and-tie crowd between NY and Boston at up to 150 mph… until it doesn’t. After experiencing multiple mechanical fails first hand on a recent trip, we started going backwards. I immediately tweeted the situation and included #delta as a way of notifying powers-that-be my next trip might involve alternative transportation. Little did I know they were watching. Within 90 seconds, a return tweet offered both apologies and assurances we’d resume in short order. Moments later we were rolling. I tweeted my thanks and so did they. #LoveOnTheRails and #CustomerForLife.

What a difference compared to Saks Fifth Avenue. As the whole Amtrak episode unfolded in real time, Saks sent me an email promoting Purses and Party Dresses, even though my preferences clearly include M for male. Already on edge, I texted Customer Service. ‘Unfortunately we don’t offer an option’ for emails by gender. But wait, you have the data. I’m a guy and I buy guy stuff. Don’t you realize I don’t care about purses on sale? Apparently not. After several more canned responses like ‘How can we help you?” I realized they weren’t listening anyway and I cancelled my account. Thank goodness Amtrak was moving.

Hard to imagine two more different outcomes. While each company responded in real time, one pointed to a solution while the other fumbled the ball. What’s especially poignant is how a former government monopoly beat the pants off a legendary retailer on customer service. The problem… data paralysis

Salesforce.com Chief Digital Officer Vala Afshar estimates companies capture only 1% of available data, as 90% of the data has been created in the last two years and companies haven’t caught up. We’ve gone well past iPhones tracking you on GPS. Retailers now record your movements within the store. As a result, data transmitted across mobile devices has risen 8x since 2012. Cisco predicts 10-12 fold by 2017.

Mobile Data Explosion

Petabytes/Month

The question is how to keep up, and even highly respected leaders confess they are struggling. I spoke with GE Vice-Chair Beth Comstock at a leadership conference in Boston mid-March. Before introducing her on stage to a group of several hundred C-suite executives, she offered a stunning revelation. “I am so uncomfortable right now.” Nerves I wondered? Hardly. She was referring to accelerating change and overwhelming data loads pushing both systems and people to the brink.

Beth also shared an anecdote describing how board level execs scrambled when current CEO Jeff Immelt recently suggested scrapping what they knew and embracing what they didn’t. Uncomfortable indeed. Curiously, one day later the Chief Marketing Officer of a $7B tech company used the same word…uncomfortable. He added “15% growth in a 2% GDP world doesn’t happen by accident. All this change and working 24/7. We’re totally exhausted… it’s all so uncomfortable.”

While the Internet of Thing (IoT) enables impressive demos at SxSW (think smart shirts which generate heat maps of your torso on an iPhone) data overload is wreaking wreaking havoc on companies. As Mr. Afshar of Salesforce.com asserted, “There are no IT employees. We are all IT and every company is digital.”

THESE ARE POWERFUL WORDS.

“There are no IT employees. We are all IT and every company is digital.”
“There are no IT employees. We are all IT and every company is digital.”
“There are no IT employees. We are all IT and every company is digital.”

Mr. Afshar’s revelation reflects a generational and seismic shift which will spawn a new breed of entrepreneur focused on a new approach we call Streamlining. At the same panel in Boston, former Akamai CEO Paul Sagan implored attendees to “Communicate your digital vision so every employee can understand why his/her role will expand as a result the increased knowledge data imparts.” This is why some technology companies have begun carving out a new position in the C-Suite called Chief Digital Evangelist. Equal parts Visionary / Strategist / Manager, CDEs will become increasingly important to large enterprises. They are the new brainiacs.

True, data visualization companies like Tableau (DATA), as well as predictive analytics companies like Qlik (QLIK) and Splunk (SPLK) are already on the scene. They represent Gen One and there will be more. Some will begin as elite groups within consulting companies like Accenture, ultimately getting spun out to at premium valuations. Others will be startups with several employees, attracting VC capital in quick and successive rounds. Any software company which can help rationalize reams of data in human terms will become highly sought after and garner premium valuation. Our job as investors is to identify these new Streamliners. We believe this will emerge as an important investment theme over the next several years and we plan to position accordingly.

GE spinout Genepact (G) pioneered this so-called streamlining, and it has since trademarked an approach it calls Lean Digital. As explained to me by lead architect and CMO Gianni Giacomelli, Lean Digital provides a holistic solution to data management by aligning front, middle and back office functions end-to-end. Legacy systems burdened by looping workflow patterns and bolt-on solutions are out. Linearity and logic are in. This is the new model, and here’s our take on what it looks like.

Lean Digital Approach

Proactive Value Creation

Nearly every consulting company (Accenture, McKinsey, etc.) offers process improvement as part of its suite of services. However very few are pure-play, or close to pure-play systems integrators like Genpact. The company conducted a survey of 100 large U.S. enterprises and concluded 45% rely on outdated legacy systems while 36% struggle with change management. Given global annual software and services spending of $2.7T (Gartner), the potential revenue opportunity to help companies realign systems and integrate metadata is significant.

Genpact revenue growth has averaged 7-8% since 2014 and will accelerate to 10% into 2017 based on consensus forecasts. We like this year’s earnings growth outlook of 12%, though the 18.5x P/E multiple make us more inclined to buy on pull backs.

Five9 (FIVN) is another IT systems pure play we are actively watching. The company creates customer service software aimed at significantly improving call center effectiveness… Saks may want to give them a call. Imagine calling customer service and not having to repeat your account number each time your are passed along the chain. Actually, imagine not getting passed along at all. One person would have access to your ENTIRE account history and be empowered to provide solutions in realtime without putting you on hold.

I interviewed Founder/CEO Mike Burkland at the NASDAQ Market Site and he outlined two pathways for growth over the next two years. First, FIVN has recently partnered with Salesforce.com (CRM) to integrate their software into the Salesforce customer relationship management platform, meaning Salesforce customers can seamlessly become Five9 customers. This is Uuuuge. Second, Five9’s revenues are less than 1% of the $24B addressable market for call center services, so there’s plenty of potential upside (15.8M call service agents globally X $150/month for Five9 software X 12 months = $24B). Management has made its case to investors at five growth conferences in five months (Barclays, Needham, Northland, Pacific Crest, Roth) and 5 of 6 analysts rate shares a Buy. The average 12-month target of $10.50 implies 35% upside.

One final point from Rob Harles, who heads the Social Collaboration practice for Accenture. He notes two thirds of the S&P 500 components turn over every ten years, meaning innovation is the essence of relevance. He suggests “beehiving” small groups of highly talented employees on a regular basis and presenting them with a mandate: Figure out how to put us out of business. Thanks for the tip, Rob.

Streamliners

Companies Streamlining Enterprise IT