Bullseye View (Issue #17.4 – 11/11/16)

Bullseye View

S&P 500 Index – 2164 +5.90% YTD

The Index is expensive at 20.2x trailing earnings, but in a world of few alternatives (negative rates in Europe and Japan as well as questionable growth in China) the U.S. stands out. Trump’s election paves the way for tax reform and reduced regulation, both of which are business friendly. However, his stance on trade implies protectionist policies aimed at preserving domestic jobs. This is potentially a significant negative, since S&P 500 companies earn 70% of revenues overseas. Sector selection is key. Growth and Inflation are in, Defensives and Income are out.

10-yr Treasury -2.15%

U.S. Treasury bonds yields rose 33 basis points over the three days following the election, reflecting anticipated inflation associated with higher presumed income/spending from Trump-driven tax cuts. This is both highly presumptive and exceedingly speculative, as tax reform is many months away at the earliest. By the same token, rising wages argue inflation is already brewing. Fed Funds Futures currently peg odds of a December rate hike at 84%, a new contract high. Fed Chair Yellen has told us she wants to let the economy run hot. Bond traders (courtesy of Mr. Trump) are already doing the job for her.

Gold – $1,224/oz +15.48% YTD

Gold’s $40 decline during election week may go down as the second biggest surprise associated with November 8th. Rising inflation expectations argue for higher gold prices. The uncertainty of a Trump platform argues for higher gold prices. But investors want none of it. They are deploying capital into growth equities which should benefit from a new business friendly White House. Safe havens are not in vogue with America “open for business.” I have been negative gold and gold miners, though I already covered shorts and have no position currently. $1,200 should provide support, especially if inflation indicators accelerate.

Oil – $43.41/bbl +17.20% YTD

NOTHING has changed here… OPEC is powerless, Iran wants to regain share and U.S. shale producers are profitable down to $32-35/bbl. In short, the world is awash in oil and there is little reason to buy at the moment. I sold the favored E&P names (CXO and EOG) when oil crested near $52 and gas hit $3.30. We will have our chance to buy them back. For now, I have no E&P positions in energy. Trump is likely to be fossil fuel friendly (which will help the 200-plus stalled pipeline/infrastructure projects), but excess supply is a far more important determinant of price currently.

Copper – $2.51/lb +17.52% YTD

Copper rose a staggering 21% between Election Day and Friday morning’s early session. It marked the largest three-day move since 1986, and it was PURELY driven by emotional buying associated with the prospect of a Trump-driven infrastructure initiative. Short at your own peril, but this is not reality. In a related vain, world #1 copper producer Freeport-McMoRan Inc. (FCX) popped 25% in three days. If you want to play the short side, write calls here. The implied vols are epic. Please call to discuss specific strategies.screen-shot-2016-09-17-at-11-27-27-am

Ahead of Your Skis (AMP – Issue #17.2 – 11/11/16)

Ahead of Your Skis
14 Stocks Too High on Trumphoria 

  • The 10% rebound in U.S. stock futures from Election night lows marks the largest 3-day run since 2009

  • 51 stocks in the S&P 1500 Index rise at least 20% in the two days immediately following Election Day

  • Perceived Trump-friendly companies include Energy, Financials, Healthcare and Infrastructure

  • Excessive price dislocations and extreme option volatilities create opportunistic short trades

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Skiing “double blacks” off the summit of Aspen Highlands is one of the craziest, most exhilarating things I try to do at least one a year. Getting that close to total disaster, and somehow still managing to have fun in the moment is beyond compare. The key is doing exactly the opposite of what you’re mind is telling you: Face directly downhill and get over your skis so the edges can bite the snow. Only one catch, don’t get too far forward, or you’ll tumble farther than you’ve ever imagined. It’s an apt metaphor as U.S. equities stage their strongest three-day rally since 2009, and a select few have ignored Ski Patrol altogether. Certain stocks perceived as beneficiaries of a Trump Presidency have risen as much as 35%, despite lack of specific news and an Inauguration still two months away. These stocks are WAY ahead of their skis… and just like at Aspen, the pending fall will not be pretty.

President-elect Trump is pro-business, anti-regulation and decidedly populist. Banks and Healthcare have rallied on his pledge to dismantle Dodd-Frank and ACA. Infrastructure has rallied on his promise to double Mrs. Clinton’s pledge of $250B over five years. Aerospace is up on based on a speech promising 15% increases for Department of Defense. Some of these are core tenets and likely to stick, others are harder to quantify, but the market has spoken.

The Trump Effect
Day After Elections (% Chg)

Two Specific Examples

Please note: My goal is to highlight some of the companies which have moved the most, and yet have no definitive catalyst on the horizon. I’m calling this Trumphoria. To be clear, these are highly opportunistic, short-term positions geared mostly for options traders. If they don’t feel appropriate for your own longer-term orientation, don’t do them. Instead, consider them provocative conversation starters with co-workers and clients about what could come next.

1. Ameriprise Financial, Inc. (AMP) +25.3%

Financial advisory stocks have had a spectacular 3-day run since Tuesday’s election on the assumption a Trump Administration will scale back stringent rules governing how certain products are marketed to investors. Here’s the thing though… actually several things… this move is based on hope and what-ifs. First, the tougher Fiduciary rules meant to curb commissions and encourage brokers to promote funds from other broker-dealers (for which they generally receive lower commissions) are not even expected to take effect until 2018, so their ultimate adoption was already highly suspect. Second, the Department of Labor’s recommendation doesn’t preclude brokers from selling in-house funds, so they can still do it anyway and continue collecting profits. Third, Trump himself never directly voiced concern on this new ruling, it was simply criticized by Trump financial supporter Anthony Scaramucci. Fourth, Congress would actually have to reopen Dodd-Frank (which I admit it will likely do eventually), and repeal the entire law (good luck without a super majority) for this specific rule to get struck. In other words, this week’s 25% move is based solely on conjecture about major policy initiatives which may or may not happen over the next two years.

AMP’s top line revenue growth grew 1% last year and is forecast to decline 2% this year… not exactly inspiring. While bulls will argue it’s cheap at 10.8x forward earnings versus an average valuation of 12.8x since 2005, AMP has risen far too fast on far too little. It was in a secular downtrend pre-Trump, and his election doesn’t fix a weak company.

I’m inclined to express a negative view by writing December 115 calls at $2.00 with the stock about $110. This provides a little added cushion and generates an annualized return of 18.4% if the stock stays below $115 at expiration.

Ameriprise Financial, Inc.

2. United Rentals, Inc. (URI) +24.5%

United Rentals, Inc. is one of the fast-money crowd’s favorite infrastructure knee-jerk trades –along with aggregates producers Martin Marietta Materials, Inc. (MLM) and #1 global copper producer Freeport-McMoRan Inc. (FCX). Traders swoop in to buy these names whenever politicians start talk shovel-ready projects creating “good paying jobs for hard working Americans.” The problem is few projects are shovel ready. In addition, Congress already approved a $275B Highway Infrastructure Plan last year. With taxes likely to decline, and a GOP Congress less willing to spend money it doesn’t have, the case for doubling down on infrastructure spending seems hard to imagine. True, Congress could pass something symbolic in the First 100 Days to demonstrate commitment and begin rewriting its “Do Nothing” moniker, but this is all speculation… and that’s exactly my point. Hope, hope, hope.

URI’s earnings growth has fallen from +41% in 2014, to +16% in 2015, to +2% this year. Analysts tracked by Bloomberg forecast 2% growth next year and into 2018 as well. If the country’s leading equipment rental company can’t do better than low single digits during the strongest construction boom in decades (the current number of hotels under being built will increase total rooms available nationally by 10%), then I fail to see how an as yet indeterminate infrastructure program will move the needle for URI. Higher oil and gas prices will boost demand for equipment, not campaign promises, especially in light of URI’s recent 1.7% reduction in rental rates.

I suggest writing the December 100 calls at $1.25 with the stock at $90. This position allows me to reflect a negative view while providing a12.5% cushion if the stock continues to rally. Looking at the chart, I have a hard time seeing URI rally above $105, however euphoric traders may get between now and December expiration. If the stock stays below $100 at expiration, this position generates a 14.5% annualized return.

United Rentals, Inc. (URI)
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I found a total of 15 companies in the S&P large and mid-cap indicies rising on Trumphoria, i.e. potentially compelling fundamental catalysts which are as yet unsubstantiated. Please feel free to call me at 917.710.8347 if you’d like to discuss specific options trades. While not core to long-term fundamental investing, these positions allow us to test our intuition at the margin, and they are highly satisfying to get right.screen-shot-2016-09-17-at-11-27-27-am

Trumphoria’s Fourteen
3-Day Returns 11/7-10

Billion Dollar Cannabis Gel (ZYNE – Issue #15.3 – 10/14/16)

Billion Dollar Cannabis Gel
A Patented Approach to Pain & Epilepsy

  • Cannabis sales will total $7B in 2016 and could triple by 2020 according to researcher Arcview Market

  • Several dozen biotechnology companies are focused on the perceived analgesic benefits of cannabinoids

  • Addressable patient markets for cannabis-derived compounds include epilepsy, osteoarthritis, neuropathy

  • Bloomberg will feature a Cannabis symposium in November for family offices and high net worth clients

Scientists, regulators and millions suffering from pain are trying to get their hands on cannabis –but not the kind you smoke, eat, or grow in an alley. This is the cleaner side of marijuana. One small biotech company has figured out how to synthetically manufacture the plant’s two defining compounds, cannabinoid (CBD) and tetrahydrocannabinol (THC), then deliver to them to patients as a wearable patch or topical gel. Preliminary results are impressive: No nausea, no high, no pain… and for investors, no correlation to the S&P 500. The breakthroughs are so promising five separate Phase II trials are either planned or underway. If recent results from a competitor are any indication, FDA applications could follow. From backyard contraband to laboratory legitimacy, pot has grown up.

screen-shot-2016-10-11-at-2-44-06-pmZynerba Pharmaceuticals (ZYNE) has been getting a lot of attention recently, more than most companies valued at just $132M. Its two patented compounds are synthetic versions of the pain-suppressing, anti-inflammatory chemicals which appear naturally in marijuana, and unlike competitors, Zynerba has figured out how to transmit them through the skin, avoiding many of the side effects associated with oral ingestion by regulating chemical flow more evenly. Its 5 independent Phase II trials are fully funded through 2017, and Zynerba owns its two proprietary compounds outright, with patent protection for 14 years.

  • ZYN002 is a CBD transdermal gel which appears to lower the incidents of seizures among patients suffering from epilepsy, as reflected in an initial Phase I trial focused on Zynerba’s unique transmission mechanism. A Phase II trail is now underway involving 180 adults, with top line data expected 1H 2017. An estimated 2.2 million Americans suffer from epilepsy, and another 3.1 million in Europe and Japan. ZYN002 has two additional applications: Osteoarthritis and Fragile X Syndrome (an autism-like genetic condition affecting 71k). Osteoarthritis affects 31 million Americans, so the potential commercial opportunities here are significant. As with the lead Phase II trial for epilepsy, results for the Phase II trials involving Osteoarthritis and Fragile X Syndrome will be available 1H 2017.
  • ZYN001 is a patch formulation of synthetic THC. By keeping THC out of the digestive tract, hallucinatory side effects are avoided and clinicians can instead focus on the perceived pain-relieving (analgesic) benefits of THC. Phase II studies begin early in 2017 for two applications: Fibromyalgia and neuropathy, or chronic pain. These are also potentially significant markets in the U.S., with 5.6M and 14.0M patients respectively. This will be the first major study involving the patch transmission in humans, though Zynerba has already demonstrated success in animals. In addition, these studies will mark the first time THC’s analgesic benefits have been tested for fibromyalgia and neuropathy.

The Scientific Side of Pot

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Okay, I admit this is heady stuff, but here’s the key: I want to allocate a portion of capital to uncorrelated and unique technologies as a way of diversifying and distancing capital from the drone of Fed policy, low GDP and excessive gov’t regulation.

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Zynerba offers a promising, patent-protected technology which could serve millions of potential patients globally. It could also prove an excellent acquisition for large pharma if even one of its five current Phase II or pending Phase II studies moves closer to commercialization. I should also note the company has sufficient cash to see each Phase II trial to completion through 2017, given $32.1M as of 6/30 and a quarterly burn-rate of $4-6M. While subsequent Phase III trials necessary for approval would require additional capital, the company could likely attract a licensing partner or float additional stock. Here’s the take from H.C. Wainwright & Co. analyst Corey Davis, Ph.D., who initiated with a BUY on October 7.

“Cannabinoids are quickly becoming medicalized, and the pharmaceutical industry has moved closer to capturing the clinical benefits with validated trials acceptable to the FDA. The likelihood of success is higher than normal for the average pre-Phase II company. This is not baked into the current valuation and Zynerba is not as early stage as many believe… given the validation of CBD from the success that GW Pharmaceuticals has recently had with Epidolex Phase III trials [as 88% of subjects responded positively].”

The comparison between Zynerba and GW Pharmaceuticals PLC (GWPH) is meaningful. GW has tripled since March on a series of positive outcomes for its own cannabis-related treatment for epilepsy. Zynerba has risen about 40% in sympathy. The difference however is that GW’s regimen is administered orally and ingested, producing adverse side effects, whereas Zynerba’s patch/creme solutions avoid the liver and GI tract altogether. The hope among analysts like Dr. Davis is that Zynerba replicates GW’s 88% response rate but with fewer complications… and its stock rallies by an equal magnitude. All six analysts covering Zynerba rate it a buy and the average target is $31, up about 2.5x from the current price of $12.50.

Hand-In-Hand
Zynerba & GW

The Trade

At the moment, Zynerba’s stock price is arguably more reflective of GW Pharma’s success than its own, having risen on positive GW data well ahead of its own Phase II data. due next spring. As a result, Zynerba is a stock to buy on pullbacks, ideally closer to $10. Currently it’s $10.90. Without quibbling too much over a few dollars when playing for a triple, here’s the action plan.

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Buy the stock under $11. The green trend line of support is about $8.50, and trial results are not expected until next spring, so we can take our time building a position.

Write puts on down days. Zynerba puts trade at wildly inflated implied volatility premiums, making them particularly appealing as sales. Remember, writing a put means we potentially buy the stock if it trades through the strike. Sell the November $10 puts at $1.00 with the stock at $10.90. Either we’ll become buyers at $9.00 (close to the $8.50 trend line) if the stock declines, or we’ll generate $1.00 in income over 35 days if the stock rallies or trends sideways. That’s 96% annualized.

Writing out-of-the-money puts for the next year at 96% annualized means, we’ll collect enough premium to own the stock for free. Good science meets good trade. screen-shot-2016-09-17-at-11-27-27-am

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Turning the Aircraft Carrier (PCY – Issue #15.2 – 10/14/16)

Turning the Aircraft Carrier
Two Debt ETFs Caught in the Wake 

  • IMF officials voice serious concern over record public and private debt now 225% of global GDP

  • Bridgewater’s Ray Dalio and Janus’s Bill Gross call bond market “clearly overvalued”

  • China and Hong Kong lead debt growth as a percentage of GDP since 2008

  • Shifting spreads between key risk instruments indicate capital flight to home markets

 

The TradeThe USS Harry Truman stretches three football fields in length and provides pilots like my friend Steve about 4.5 acres of flight deck when it’s time to land. To say the ship is big is to say the sun is bright or the the moon is high. These magnitudes are so unimaginable we don’t have the words… and one is even man-made!. Steve and I catch up every year at our high school reunion and I pepper him with questions like how fast can a carrier go, and how long does it take to turn around? The answers are understandably classified, so our honorable aviator suggests cool YouTube links https://www.youtube.com/watch?v=d4KnCqcTEOU and offers nebulous comments along the lines of “Faster than you’d think, but still a long time.” Carriers need time, and so do investors. As we debate the IMF’s warning last week about unsustainable leverage, I find myself wondering: How long will it take to turn this giant around and put low rates in our wake?

Warning Shot

The International Monetary Fund (IMF) sprang quite literally from the ashes of WWII in order to foster global stability and long-term growth through international trade, monetary cooperation and focused lending initiatives. Its 189 members gather twice annually to offer an assessment of their current outlook and to highlight potential flash points. Their recently published Fiscal Monitor ahead of the Oct 7-9 meeting in Washington offered a particularly sober assessment, arguably a shot across the bow aimed squarely at low rate loving central bankers.

“At 225% of world GDP, total global debt (government, household, and non-financial corporate) is currently at an all-time high, which as documented in an extensive literature carries great risks. The reason is that the absence of fiscal buffers curtails the ability to conduct countercyclical fiscal policy, especially in emerging market economies. Highly indebted borrowers will sooner or later decrease their consumption and investment, as they are unable to service their debt and can no longer borrow. This is particularly relevant now… private sector leverage has increased significantly over the past few years… setting the stage for a vicious feedback loop. It is clear that meaningful deleveraging will be very difficult without robust growth and a return to normal inflation [neither of which is currently apparent nor remotely evident in the forecasts].”

Bloomberg published the IMF’s lead chart on the front page of its own Economic Brief to underscore concern about global leverage and further the conversation. NEVER has the world reached such high levels of debt. The IMF’s calculation includes all debt owed/issued by governments and non-financial corporations globally, as well as all borrowings held by households globally. It’s a comprehensive figure and a loud wake-up call. We’re not simply talking about debt issued by central bankers which can write checks with the stroke of a pen and increase money supply with touch of a printing press. This is all of us.

Churning Waters

Two-thirds of the $152T in debt cited by the IMF is private sector, meaning Main Street and Wall Street are leveraged to the hilt. It’s 2008 all over again, and the vast majority of countries around the world have piled on, from developed markets to emerging markets. The IMF data paints quite a picture. Notice Hong Kong and China at the bottom of the charts below. Their private debt levels have risen by 110% and 70% in GDP terms since 2008.

Private Debt Change as % of GDP (by country)
Developed Markets & Emerging Markets
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IMF Fiscal Chief Victor Gaspar sounded the bosun’s whistle at last week’s summit, telling attendees “History has taught us that it is very easy to underestimate the risks associated with private debt.” These are sobering words for a polite statistician, but hardly news to global portfolio managers who’ve already ordered helmsmen to starboard. Their new course is evident in the churn of the past several weeks. Capital is steaming back to port.

  • German Bunds have moved back into positive territory for a third time since July as global investors recognize the cost of safety (negative rates) is untenable long-term.
  • The U.S. 10-yr has popped to 1.74% as Fed Fund Futures on the CME indicate 64% odds of a December rate hike.
  • The window to fund purchases of U.S. Treasuries funded by short sales of Japanese JGBs and German Bunds has finally closed, as rising FX premiums on forward hedges negate arbitrage margins.
  • Much beleaguered U.S. banks have appreciated 14% against dividend-paying utilities since June 30.

Dalio & Gross Sound General Quarters

Bridgewater Associates Founder Ray Dalio sits atop $150B in assets, much of which is deployed in global bond markets and he too is concerned. On the same day the IMF released its none-too-smiley Fiscal Monitor, Mr. Dalio addressed the New York Fed’s 40th Annual Central Banking Seminar.



“Long-term debt cycles are approaching late-stages. Central banks are pushing on a string, both because interest rates are approaching their maximum lows, and because the effectiveness of QE is approaching its limits as risk premiums and spread compress. This is a global problem. We see an intensifying financing squeeze from slow growth, low return and high debt. It would only take a 100 basis point rise in Treasury bond yields to trigger the worst price decline in bonds since the 1981 bond market crash. And since those interest rates are embedded in the pricing of all investment assets, that would send them all much lower. Rarely do we as investors get a market that we know is overvalued and that approaches such clearly defined limits as the bond market right now.”

If you think Mr. Dalio is either alone in his view or simply overreacting, please think again. Bill Gross first sounded the alarm on negative rates in Europe over a year ago. He calls German Bunds “the short of the century.” On Friday October 6, after the U.S. Department of Labor released a September unemployment rate of 5.0% (the highest since April) and disappointing non-farm payroll gains 154k (only marginally above the breakeven figure to accommodate population growth), Mr. Gross addressed the current debt bubble on Bloomberg.

“Because of this highly levered world, which I do not think we’ve experienced as far back as 70 years, central banks cannot afford to raise rates… because 50 or 100 basis points might rake the system. Return is not proportionate to risk, and capitalism itself at the margin starts to turn inward.”

The Trade

When markets turn inward, capital goes home and it doesn’t return for a long time. This problem is especially acute for emerging markets, where portfolio managers have turned in search of yield given unacceptably low returns closer to home. Pros look at the J.P. Morgan Emerging Market Indicies on sovereign and corporate bond spreads (JPEIGLSP and JBSSCOMP Index <GO> on Bloomberg, respectively). Spreads have contracted significantly over the past year, and while not at all-time lows, they are getting close. Put another way, there’s a lot more room for them to widen than to contract. Helmsman: Hard to port!


You can see the opportunity quite clearly on the chart of the PowerShares Emerging Markets Sovereign Debt Portfolio ETF (PCY). In addition to rising significantly this year as capital moved into the region, note how the index has fallen hard each of the past three Decembers as capital repatriates into yearend. Combine seasonality with huge inflows and two-fold price appreciation relative to the past three years, and I see something which begs a call to stock loan… I need a borrow and I want to go short.

Ghosts of Christmas Past
Emerging Markets Sovereign Debt ETF (PCY)
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PCY trades an average of 1.7M shares per day ($51M notional). It holds 86 positions in the sovereign debt of countries across the globe. The largest single country exposure is Venezuela at 4.27%, followed by Brazil, Columbia, Indonesia, Kazakhstan. Top ten holdings account for 16.75% of capital. Dividends are paid monthly and the fund yields 4.90% annually. If you are short, you are also short the dividend, so the monthly cost is 41 basis points. You can also short corporate debt in emerging markets via the iShares J.P. Morgan USD Emerging Markets Bond ETF (EMB), though its dividend yield is slightly higher at 5.18% and the chart offers slightly less room to fall. My trade is to short PCY above $30, with a target of $27 by December 31. screen-shot-2016-09-17-at-11-27-27-am

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Change of Possession (Issue #15.1 – 10/14/16)

Change of Possession
Ten Offensive Names as Defense Gets Benched

  • Tech, Energy and Banks have beaten defensive Telecom and Utilities by two to one since July

  • Record S&P 500 payout ratios highlight company and investor preoccupation with income

  • September FOMC minutes indicate a Fed poised to raise rates in December on strong job gains

  • Prepare for a rising rate environment by rotating into growth companies like the 11 profiled here

 

Imagine a football game where linebackers scored and quarterbacks tackled… not just the occasional pick six or on-sides kick… but quarter after quarter. Fans would shout in disbelief and coaches would throw their clip boards in disgust. If it happened the following week, there’d be talk of rewriting the playbook. A third episode would confirm the trend. Breathless commentators would explain how the world had changed and why It’s different this time. The best players would aspire to defense, and general managers would build franchises around safety. Impossible? Look at Wall Street’s winners of the past two years. Utilities and Telecoms have marched up the field to dividend cheering crowds as flashy Semis and Banks have languished on the bench. Dee-fense has ruled, but not any more. Coaching staffs dusted off the old playbook at pre-season in July. Look at the scoreboard now. Offense owns the field.

The TradeOffensive sectors have dramatically outperformed since the beginning of July. Semi-conductors have led the way, reflecting a perception that rising economic growth creates demand for goods and the sensors which increasingly power them. Energy is finding a bid as oil rises to $50, and banks are finally attracting buyers on the assumption rising rates will improve net interest margins. As for the dividend paying sectors, they are now officially off the roster.

Growth Is IN… Dividends Are OUT
S&P 500 Sector Returns Since July 4th

Several factors have contributed to the pivot from D to O, and like any close game that keeps us on the edge of our seats, it’s not one-sided. Consider the current field conditions:

  • Higher Rates – The Fed has made clear it has pivoted from “accommodation to a more normalized” rate environment as “a substantial majority now view near-term risks to the economic outlook as roughly balanced. Notably, only 5 of 17 members envision a scenario where inflation falls below the current rate of 1.1%
  • Stronger Jobs Market – Weekly jobless claims of 246k remain at 42-year lows and headline unemployment of 5% appears like the new structural low. As former Fed Vice-Chair Alan Blinder taught me in Econ 101 at Princeton, the Wage-Price Spiral is ultimately what drives CPI higher, and strong employment metrics generally lead to higher wages.
  • Dividend Payouts Maxed – S&P 500 companies currently distribute 55% of earnings in the form of dividends, near the upper bound of the historic range. Yet earnings have fallen five quarters in a row and dividend growth has slowed to 4.7%, less than half the 3-year average according to FactSet. Coupled with sky-high valuations, dividend sectors look tired. No wind-sprints today. Time to hit the showers.

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The combination argues for a move into cyclical, high-quality growth names… cyclical to reflect an improving labor market and rising rates, high quality to reflect the importance of selectivity with GDP still below 2%. I also want to deploy capital away from the Division I names of the S&P 500 which get all the attention, focusing instead on faster growing companies of the S&P 400 Midcap Index. I think this is important at this point in the cycle. Macro talk from the Fed has dominated headlines and portfolios for too long. If we believe in the thesis of U.S. economic growth, we should place our bets on companies with good field position. To me, this implies midcaps not large caps, as they have more opportunities to grow. Another key point, my stock screen for high quality recruits prioritizes strong cash flow and low debt. Play ball.

High Quality Recruits
Only 10 of 400 Make the Cut

This screen generated ten buy candidates from the 400 companies considered. On average they are up 17% YTD. They generally serve niche markets are are growing rapidly. Six have no long-term debt (denoted by n/a above under Debt to Cashflow). Seven offer attractive entry points, two are respectable (IDCC, TYL) and FII needs to find a tradable bottom. Charts for each are shown below.

Astute readers will recall MarketAxess (MKTX) as the subject of my Robo Trader write-up on July 22.  The company is turning the bond market upside down by providing a listing platform where buyers meet sellers directly, introducing transparency and displacing dealers in the process. The company reports earnings on October 26 and is currently trading at its support line. screen-shot-2016-09-17-at-11-27-27-am

Abiomed Inc. (ABMD)
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Align Technology, Inc. (ALGN)
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Cognex Corp. (CGNX)
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Federated Investors, Inc. (FII)
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Gentex Corporation (GNTX)screen-shot-2016-10-13-at-3-29-40-pm

InterDigital, Inc. (IDCC)
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Manhattan Associates, Inc. (MANH)
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MarketAxess Holdings, Inc. (MKTX)
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Tyler Technologies, Inc, (TYL)
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United Therapeutics Corporation (UTHR)
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Government’s Greatest Gift (Issue #14.3 – 10/02/16)

Government’s Greatest Giftscreen-shot-2016-09-30-at-11-55-01-am
How to Double The S&P 500

 

  • Dividend reinvestment in pre-tax accounts generates significant outperformance over time

  • Only 54% of U.S. working adults participate in retirement benefit plans

  • Second quintile dividend stocks offer the best risk-adjusted returns

  • Q4 rebalancing yields SIX NEW DIVIDEND STOCKS

 

American illustrator J.M. Flagg created his iconic image of Uncle Sam for Army recruiting posters in 1917. He borrowed the nickname from the troops themselves. They’d affectionately dubbed an Army meat supplier Uncle Sam for stamping the letters “US” on steaks headed to the front during the War of 1812. Flagg loved the story and decided it fit his image of what government ought to represent. Our perception of government may have shifted somewhat, and arguably pork has replaced steak as Washington’s meal of choice, but there’s still one feast every American deserves: Tax-deferred compounding and 100% dividend reinvestment in a 401(k) account.

Congress first introduced language on tax deferred savings plans into the U.S. tax code in 1978. Today, more than 88 million Americans participate in at least one of 638,390 registered defined contribution retirement plans according to the American Benefits Council. The number may sound impressive, but there’s a problem here. Only 54% of working Americans engage in pretax retirement planning based on data from the Bureau of Labor Statistics. This is absolutely crazy. Pre-tax investing is the single greatest mass market opportunity for individuals to build wealth and retire in time to enjoy the fruits of their labor.

401(k) Ground Rules for 2016

  • Pre-tax investing equates an interest-free loan from the government, since every dollar up to a maximum contribution of $18,000 accrues without paying tax until the time of withdrawal
  • Many employers match contributions, and the government allows a combined total of $53,000 per year
  • Returns earned on investments held in a 401(k) account can be reinvested on a tax-deferred basis. This includes interest, dividends and stocks sold at a capital gain.

This last point is the real kicker, especially when you consider reinvesting dividends without paying tax. You put the money in tax-free, it generates income tax-free, and you reinvest it tax-free. It’s a triple whammy, and it repeats every year. You are compounding your money on the government’s dime. 401(k) accounts represent the single most advantageous retirement plan available and we should all be participating. THANK YOU Uncle Sam.

To better illustrate the point, consider returns on the S&P 500 Index relative to its Total Return Index, where dividends are reinvested pre-tax and commissions are zero. Every time a company in the index pays a dividend, the amount automatically goes towards purchasing additional shares.

Thank You Uncle!
Pre-Tax Dividend Reinvestment
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The difference is staggering when seen on the chart above. The Total Return Index produced nearly double the return over the same period (1,120% compared to 658%). The reason is simple: Dividends were reinvested pre-tax and then compounded pre-tax for 25 years. Again, it’s as though the Government is giving you an interest-free loan, enabling you to reinvest dividend income without paying tax. Yes, you will eventually have to pay taxes on the proceeds when you withdraw funds in retirement, but you will have earned income on the Government’s dime for decades. This is a very good deal.

$2.06 Million in 25 Years

Let’s put some real world numbers on this to further prove the point. We’ll be especially conservative in our calculations. We’ll assume the company does not match employee contributions, and the IRS maintains its current maximum of $18,000 per year rather than adjusting upwards for cost of living. Plugging in actual average annual returns from 1990 to 2015 of 8.5% for the S&P 500 Index and 11.4% for the Total Return Index (Bloomberg data), the outperformance of dividend reinvestment in a 401(k) exceeds a million dollars.

Power of Pre-Tax Compounding
S&P 500 Index Returns (1990-2015)
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The same S&P 500 stocks in a 401(k) account produced nearly double the return of a standard index fund. In this real-world example, $18,000 contributed annually became nearly $2.1 million over 25 years. This is the power of pre-tax investing coupled with compounding over time. For all the talk (and effort) of finding the next great growth company in Silicon Valley, buying consistent dividend-paying companies and reinvesting the proceeds on a tax-deferred basis works exceptionally well.

Most 401(k) plans offer employees multiple investment funds from which to choose and indexing to the S&P 500 will likely one of them, possibly even the default option. However, choosing an index fund does not guarantee dividends will be automatically reinvested. You have to read the terms of each fund carefully and then either chose a fund which specifically reinvests dividends, or elect dividend reinvestment through the Administrator.

Attention Stock Pickers

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For the vast majority of people, selecting an index fund which reinvests dividends is good enough… especially when $18,000 invested annually into a broad index fund can produce a $2.1 million nest egg in 25 years.

I also recognize some of us appreciate the benefits of stock selection. The investment team at Strategas Research Partners L.P. looked at the risk-adjusted returns of S&P 500 component stocks sorted by dividend yield. (This is simply return divided by the volatility of returns over time, measured by standard deviation). Their research showed the risk/reward tradeoff is maximized when investors buy the second decile of highest yielding stocks (i.e. stocks ranked 61-80% in terms of yield) and rebalance every 6 months.

As their data illustrates, the second quintile produced the highest returns on both an absolute and risk-adjusted basis. In other words, you don’t want the highest yielding stocks, you want the highest yielding stocks adjusted for risk. Second quintile stocks optimize this trade-off AND produce the highest returns over time.

To confirm their results myself, I back-tested the strategy with Bloomberg Analytics on the Dow Jones Industrial Average (DJIA) between 2000 and 2015. The second quintile group outperformed the overall DJIA by a margin of three to one, returning a cumulative 151% compared to 52%. The point is, if you participate in a self-directed 401(k), you have greater leeway to select stocks in your portfolio. Uncle Sam presents one gift, and data presents another. Combine them, and you’re building wealth.

DJIA Second Quintile Dividend Winners
As of September 30, 2016
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Investors looking to incorporate the second quintile dividend strategy can follow this simple methodology:

  • Buy the second quintile dividend components of the DJIA as of 09/30.
  • Rebalance on 03/31, and every 6 months thereafter.
  • Buy new shares of stock with proceeds from dividend distributions.
  • Recognize the backtest revealed 51% turnover annually, meaning three stocks were bought and sold on average every 6 months.

Clearly, EVERYONE should have a 401(k) plan and begin saving as early as possible. In addition, everyone should maximize the full benefits of pre-tax investing by reinvesting dividends earned in a 401(k) plan AND utilizing company matching programs where possible. Finally, hands-on investors may be able to produce additional returns by utilizing the proven dividend selection strategy outlined above.

At the very least, educate yourself on the full spectrum of 401(k) benefits and options by speaking with your financial advisor and visiting IRS.gov. screen-shot-2016-09-17-at-11-27-27-am

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

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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.

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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.

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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

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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)
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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

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  • 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

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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

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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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