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.
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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.

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Banks

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 https://bullseyebrief.com/home-siberia-issue-12-3-090416/ 

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. https://bullseyebrief.com/matrix-goes-mainstream-issue-1/

Energy

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.

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REITs

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).

Staples

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. https://bullseyebrief.com/band-aids-beverages-bleach-issue-6-1/ 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.

Pre-Approved?
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 https://bullseyebrief.com/buy-the-buyers-issue-2-1/ 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
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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
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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
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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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Is Anything Cheap? (Issue #11.3 – 8/21/16)

Is Anything Cheap?

10% Growth for 10x Earnings 

  • Only 8 companies in the S&P 1500 are growing at least 10% and trade less than 10x earnings
  • All 8 have strong current franchises but face longer-term strategic uncertainty
  • These are “story stocks” with unique fundamentals and adamant investors on both sides
  • Half present attractive entry points from a technical perspective

On last week’s podcast I asked whether anything is still cheap. It’s certainly a worthwhile question as defensive sectors like Utilities and Telecom drive the S&P 500 Index to new highs, and global pension funds plough record billions into negative yielding sovereigns. Push me a little and I’ll say “No, nothing is cheap. Global central banks have penalized cash balances to ensure we deploy every cent of capital. We’ve bid up asset prices to the point of absurdity. NY condos go for $90M!” Okay, quantitative easing has made me cynical, but not oblivious to data, nor the power of the Bloomberg Terminal. Screening the S&P 1500 for growth and price, I did indeed uncover a handful of companies which are truly cheap –one even got acquired the day before publishing. Value does exist.

Bloomberg offers users a powerful screening function which narrows large groups of securities into specific baskets based on quantitative search criteria. While my goal was to identify stocks I thought were cheap, I also wanted to consider growth forecasts and gauge sell-side support. In other words, I wanted stocks which are cheap but probably deserve to trade higher, both because they are growing and the analysts love them. Starting with the S&P 1500, I applied the following metrics:

  • Forward 12-month price to earnings ratio less than 10x
  • 2016 earnings growth of at least +10% (Q1 and Q2 actuals plus Q3 and Q4 estimates)
  • 2017 earnings growth forecast of at least +10%
  • Analyst buys outnumber sells plus neutrals
  • No more than one sell allowed
  • Minimum 20% upside to target based on consensus estimates

Cheap & Growing

Only 8 of 1500 Meet Criteria 

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Stocks are generally cheap for a reason, and a forward P/E of less than ten in an environment when the S&P 500 Index trades at 18.5x implies something is awry. Yet each of these companies is growing and is well-admired by the analysts covering them. Hence the potential opportunity for us. While my discussion is primarily fundamental, note some of these charts. They look ready to bounce. Happy hunting.

Air Methods Corporation (AIRM)

Air Methods provides emergency airlift services across North America. If you’re a stranded hiker in Death Valley and need a emergency helicopter, or a transplant patient in Atlanta awaiting a donated organ from LA, these guys are probably involved. They serve hospitals on a contract basis with 500 aircraft (mostly helicopters) from 229 bases across the U.S. They also operate emergency call centers, and about 11% of revenues come from using idle helicopters for tourism in certain locales. At an average of $12k per flight, medical cost scrutiny under the Affordable Health Care Act has weighed on shares. In addition, the tourism business slipped 1.6% YoY in the recent quarter and may obscure the core business. That said, margins have risen each of the past 3 years and the company is buying back stock.

AMAG Pharmaceuticals Inc (AMAG) 

AMAG looks down and out, but it’s not. The concern stems from upcoming patent expirations for its two lead drugs: Makena which delays prenatal births and Feraheme which treats iron deficiency for patients with kidney disease. Each drug is involved in studies which could potentially broaden approved applications and extend patent protection. Makena requires injections that can create adverse side effect, so AMAG is pioneering alternative administrations which could earn seven years of protection under orphan drug status. In the case of Feraheme, the company is engaged in a trial of 20,000 people with iron deficiency unrelated the current kidney disease application. Results will become available next year and could potentially provide new applications for the drug by 2018. As with most biotechs, the outcomes are binary and analysts are split between targets ranging from $27 to $80. The stock currently trades at $24, which suggests risk-reward favors the longs.

AMC Networks Inc (AMCX)
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What makes AMC interesting is its ability to consistently produce exceptional hits like Mad Men, Breaking Bad and The Walking Dead. That is also the challenge however… Can they do it again? So far, the Walking Dead spin-offs have done quite well. Better Call Saul attracted 3.2 million viewers  per episode in the first season and Fear the Walking Dead 7.2M. By comparison, Mad Men attracted just 2.1M per episode in its first season. Distribution accounts for 56% of revenue, and advertising constitutes the balance of 44%. Strong penetration across digital platforms is a positive, as is the international exposure provided by the 2014 acquisition of Chellomedia, but again you’re betting on hits here.

ARRIS International plc (ARRS)
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Okay, this is a crazy chart and I’m not crazy about it. A lot of gaps, and right now it looks like it’s levitating, which suggests it’s vulnerable short-term. That said, this company is the global leader in set-top box and video infrastructure equipment. Do you watch TV or stream content online? ARRIS makes it possible. The company currently controls 45% of the home broadband market in the U.S. according to IHS. There are two issues for potential buyers: 1. Whether this dominant share is as good as it gets 2. Whether mobile supplants fixed box distribution over time, and if so how ARRIS will adapt. These hypotheticals are hard to answer. Right now the company is sitting on nearly a billion in cash and posting strong growth. It’s also quite cheap at 9.3x earnings and 0.7x sales.

Bofl Holding, Inc (BOFI)
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This is a hairy dog. A staggering 44% of BofI’s stock is sold short based on a lawsuit filed last October by former a employee which alleges multiple improprieties (inflated appraisals, loan doc forgery, insufficient due diligence, etc). That said, all six analysts covering the company maintain their buy ratings as the bank continues to post double digit asset growth and strong earnings. In the most recent quarter, assets rose 30.5% YoY to $7.6B, net interest margins held at 3.7% and ROE for the 12 months ended June 30 was 19.43%. The partnership with H&R Block to cross sell IRAs is moving forward. CEO Greg Garrabrants addressed the current litigation on the most recent earnings call, “The bank is in strong regulatory standing with no enforcement actions, has not been fined a single dollar by any regulatory agency, has not been required to modify its products or business practices. Additionally, we do not foresee any further impact to the underlying business as a result of the frivolous lawsuit and the short-seller thesis. Our management team and employees remain focused on running the business.”

Mylan NV (MYL)
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David Einhorn’s Greenlight Capital doubled its position in Mylan during 2Q to 4.9M shares (14 of the top 25 shareholders increased positions during the quarter, 9 sold and 2 held steady). I like seeing a value minded activist investor increase his stake in a company, especially in Mylan’s case as it has never recovered from the gap created last year when Teva abandoned its hostile takeover bid. 86% of Mylan’s business is generic, which means margins are lower and upside is less than non-generic drug makers. In addition, there’s no dividend. Of the 8 companies in my screen results, this is probably the least compelling –though 8.9x earnings for mid-teens growth seems awfully cheap.

Rovi Corporation (ROVI)
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Rovi is like TV Guide for the 21st century. It creates interactive programming guides for cable companies  and video ad campaigns appearing on digital devices. The company is currently in the process of acquiring TiVo and the deal is on track to close by Oct. 1. In addition, George Soros bought 3.6M shares during 2Q to become the seventh largest shareholder. As for why it trades so cheap, the 2017 earnings estimate of $2.30 is LESS than the 2011 earnings of $2.40. Also of note, the company has missed estimates seven times since… that’s nearly two years worth of disappointments. As noted earlier, stocks are generally cheap for a reason, or in this case seven reasons.

United Insurance Holdings (UIHC)
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Take a bow United Insurance! I ran the screen on Wednesday night and Thursday morning it announced a merger of equals with RDX Holdings. The stock popped 9%. If only every trade were this easy! This underscores the value of running regular stock screens for growing companies trading at a discount. If we don’t buy them, someone else will.

Industrial Surprise (Issue #11.2 – 8/21/16)

Industrial Surprise

Guiding Down but Getting Bought 

  • AMTEK Inc. (AME) issues two disappointing earnings reports and notable buyers acquire shares
  • Volume spikes on down days establish $45 as triple bottom underpinning stock price
  • Management trims guidance for second time and offers detailed outlook by segment
  • $1B cash available for opportunistic and accretive acquisitions my provide upward catalyst

I’ve been trying to get excited about beleaguered industrials on the assumption every dog has its day. Now I finally have reason to pay attention. 13-F filings released this week reveal activist investor Dan Loeb of Third Point Partners has initiated a position in oft-overlooked AMETEK, Inc. (AME). To quote one of my favorite special situations strategists, Don Bilson of Gordon Haskett “It’s hard to find a name more under the hedge fund radar than AMETEK… coming out of Q1, not a single hedge fund manager was a top-30 holder.” Nonetheless, Mr. Loeb now has a stake and he’s been buying on terrible news. So have the top three shareholders (Fidelity, BlackRock and Vanguard). When avowed activists hedge funds and and deep-pocked mutual funds join forces, I pay attention.

Take a look at the one-year chart of this $11B roll-up of electronics manufacturing businesses. Three times since April the company has sold off on terrible news, including two earnings disappointments and lowered guidance. Yet each case proved a buying opportunity, which is what makes this picture interesting. Again, when strong-handed pros buy on bad news, we should try to understand why.

Buying Bad News

AMETEK, Inc (AME)

Note the volume spikes each time the stock sold-off. Clearly a lot of disappointed investors were voting with their feet, though buying ultimately trumped selling and the stock rebounded. I’m especially intrigued by the near instantaneous bounce two weeks ago when new CEO David Zapico lowered guidance. With 11 of 17 analysts rating the stock a buy, and not a single seller among them, there’s something happening here. This action is unusual, especially for an industrial stock unaccustomed to headlines.

To get a better sense for what’s happening, I’ve extracted key moments from the earnings call on August 4th, when the stock opened down 7.5% but managed to close nearly flat. You can hear how the tone of the conversation changes, beginning with the guidance cut. CEO David Zapico’s words appear in italics.

Visibility has remained limited as customers are cautious and are aggressively managing their inventory levels and capital spending plans. We do not anticipate a modest second half improvement, as we had expected. As a result, we now forecast revenue to be down low single digits. 

Stifel Nicolaus: Is it unlikely will we get another cut?

There is not going to be another cut. We feel the business has stabilized, especially energy. Our customers are telling us, based on some of the commentary you’ve heard from Halliburton, Baker Hughes and Schlumberger that rig counts have bottomed.

The two markets that are down, about 20% of our company –oil and gas and metals– are down 30%. That’s a difficult headwind to offset but we still have 22.4% operating margins and we’ve had a good operating quarter. Free cash flow was strong at $175 million in the second quarter, up 15% over last year.

BMO Capital Markets: But the truck is falling apart… 

Many of you have followed Ametek for quite a while, and in the past our forecasting process has yielded very consistent results, but it hasn’t the last few quarters. It’s a difficult environment. Customers are delaying capital projects and managing inventory aggressively. Emerging markets are challenged.

So we’re taking a different approach to forecasting. We got our entire executive office involved. We took a deep analytical review of each niche business to understand their specific forecasts and to better assess potential risk. We spoke to the financial community. It’s a more time consuming process but we felt it’s the right thing to do at this point. It’s a rigorous process and I feel confident in the results.

BMO Capital Markets: Is there a lift to the cost savings number?

Our cost reductions are $130 million for the year. We are purchasing less material… we are balanced in revenues and expenses so we have a natural hedge. Uncertainty is going to go on for some time, but we’re feeling pretty good about our exposure.

No area is immune from efficiency improvement. We are going to look at things like global sourcing, low-cost region production, value analysis, value engineering, plant consolidation… with all of the tools that we have we are going to get a healthy cost reduction target. And we are going to pair that with acquisitions and that’s how we are going to grow our earnings next year.

Robert Baird: Should we think about downshifting core growth to more of a GDP number?

Through the cycle of the last 10 years we grew earnings 16% compounded annually. We need to adapt our strategy to the new reality in the marketplace, in order to ensure we’re going to be able to double earnings over the next five years… with a combination of mid-single digit organic growth and adding acquisitions of 5-10% a year.

Stifel Nicolaus: How do you think about M&A and public deals in this environment?

We have a solid pipeline. Our sweet spot is that $50 to $200 million dollar deal, but we’ve expanded our horizons are looking up to $500 million in revenue. We do deals that add the most value and we are very selective. We have four deals done this year and we deployed $360 million in capital. We have $1 billion of capacity within our existing credit lines and cash on hand. More importantly our operating cash flow is $750 million and I think this can be a significant driver for 2016 and 2017 performance.

Jefferies: Can you give us some color on emerging markets?



Sure, I’ll go around the world. In the U.S. we were down high single digits versus last year… oil, gas and metals… in Europe low single digits. Asia is stabilizing, China is stabilizing and one emerging market I’d point out that is doing better is India with mid-single digit growth. With the strong dollar we are relocating to low cost locations, and in most situations we don’t have competitors so that give us an advantage. We are naturally hedged in most of our markets.

RBC: Do you have orders or backlog to give you confidence about stabilization?

Yes. Our backlog is $1.1 billion. If we look at the run rates, and we’ve spent a lot of detail on it, it gives us confidence in the back half of the year.

Some of the questions got a little testy, as you might expect when a company guides down twice in three months and effectively bags the analysts in the process. However, Mr. Zapico has worked at the company  for several decades and his intimate knowledge of the businesses paid off. In addition, he handled himself like a pro. Harvard Business Review contributor John Baldoni has written extensively on how effective leaders react to crises. His checklist includes five basic categories, and Mr. Zapico scores five for five.

Crisis Management Checklist

Admittedly, this is all a little touchy-feely so we need some NUMBERS. What distinguishes Ametek from other electrical/industrial manufacturers is its 2x wider Operating Margins and superior Return on Equity. As for valuation, its P/E is comparable to the market but well below the group. It’s also down on the year, which provides additional room to play “catch up.” Bottom Line: What we’re buying in AME is a management team and its ability to identify, acquire and integrate complementary businesses. I think of Ametek as a medium-term call option on improving economic growth and rotation into overlooked industrials. This theme may take time to play out, but I like betting alongside Loeb and Fidelity.

Vital Stats

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Slippery When Wet (Issue #11.1 – 8/21/16)

Slippery When Wet

3 Energy ETFs for Rational Investors 

  • Baker Hughes Index of active U.S. land-based drilling rigs rises 10% in 10 weeks
  • IEA ups its forecast of global refinery throughput to all-time high on strong refining margins
  • Mideast OPEC producers still engaging in price war over market share for term contracts
  • Energy equities up significantly since Feb lows but flat since May

Misinformation is everywhere, and it’s especially entertaining in the oil business when OPEC ministers chirp about pumping rates. Saudi Arabia’s oil boss Khalid al-Falih promises a ministerial meeting in Algeria next month to stabilize the market, even as he directed Saudi Aramco to pump a record 10.67M barrels in July at the request of customers. He’s quite the chess player, jawboning markets higher while opening the spigots and claiming it’s all about the customer. Does the world really need more oil, Mr. al-Falih? Chinese demand fell to a two year low in July, and U.S. demand has been sideways since May. Oh never mind. Your Kingdom faces a 15% budget deficit and you’re Mr. Fix It.

Maybe I’m being too harsh on Mr. al-Falih. He’s got a hard job. Sunni Saudi Arabia is effectively waging a price war with Shiite Iran to capture share, even as it desperately needs revenue for capital investment and economic diversification. Mr. al-Falih is caught in the middle, and so are the rest of us. On the one hand, OPEC’s need for cash, coupled with U.S. producers’ ability to frack new fields creates an unprecedented supply overhang. On the other, drilling shut-ins and regulatory resistance to build any new refineries in the U.S. since 1977 keeps retail product prices robust. Bull or Bear, depends who you talk to.

Say What

The Absurdity of Labels
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Amid all this noise, from pundits arguing on CNBC to record energy bankruptcies in Houston, something amazing appears to happening in the oil business: people are going back to work. The number of rigs actively drilling new wells in the U.S. has risen each of the past ten weeks and now stands at 447 according to the Baker Hughes Rig Count Index. While still 75% below the level seen in 2014 when oil cost over $100/bbl, it’s the strongest indication yet the worst may be over for the drillers.

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The rebound in drilling coincides with the International Energy Agency increasing its own forecast for crude demand, arguing strong refining margins incentivize higher operating rates. The IEA now says refinery throughput will rise by 600kb/d to a record 80.6Mb/d in the second half of 2016.

Recognize even unbiased agencies like the IEA are having trouble sorting out all the conflicting signals. Oil’s decline from $110/bbl in 2014 to a low of $26.21 last February –and about $45 today –means everyone is struggling to retool and identify a path to long term equilibrium. Drillers have slowed production volumes to ration supply and moth-balled all but the most promising wells. Bankruptcies and asset sales have concentrated firepower and operational expertise into fewer, stronger hands. It’s been painful, but forward guidance on recent 2Q earnings calls suggests some industry executives believe the market has turned and may launch a modest up-cycle in 2017.

We are beginning to see some green shoots and key unconventional plays in the U.S. onshore business suggesting that the worse maybe behind us. We expect to see an increase in the international activity by mid-2017 as governments look to replenish some of the loss revenues with lower risk projects. Similarly, we would expect shelf and shallow-water activity to file a suit in mid to second half of 2017.”

-Jeff Bird, CEO Frank’s International NV

Frank’s International NV (FI) is the largest supplier of tubular steel pipes to the oil industry, with a 35% market share of the U.S. land market alone. As the only pure play in the business, coupled with a $581M war chest of cash and no debt, Mr. Bird has expressed openness to bolt-on acquisitions. Admittedly, he just cut the dividend and sees declining cash flow into the fourth quarter, but he sees a tighter supply balance materializing in coming months and he’s cautiously bullish 2017.

Investors apparently agree with his view, having voted with their wallets this year to lift the sector 13.8%, compared to 6.3% for the S&P 500 Index. Three energy exchange traded funds (ETFs) provide exposure with varying degrees of risk and reward, depending on your own risk tolerance: E&Ps for upside; MLPs for income; Big Oil for exposure.

The Trade

I like a combination of Upside and income, meaning I’ll get paid while I wait for my gains. So split the usual position allocation of 3% into two positions of 1.5% each, where half goes into exploration and production (XOP) and half into master limited partnerships (AMJ). Like Mr. Bird, I sense a sufficient weeding out has occurred and we can begin to think about the next up-cycle. I will also add, there is no rush to own a full position. The damage was immense, so repair will take time. Buy only on down days and pick your spots. (Note: I include the basic energy ETF XLE for your reference.)

1. Most Bang for the Buck (XOP)

Investors looking to maximize operating leverage within the energy sector should focus on the SPDR S&P Oil & Gas Exploration & Production ETF (XOP). It’s a cap-weighted portfolio of 59 companies with an average one-year Beta of 1.69, meaning this group tends to move 1.69 times more than the broader market. When oil and equities in general move higher, these stocks rise even faster. Here’s why: As oil prices rise and pumping rates increase, fixed costs can be distributed over higher per unit volumes, which drives margin improvement on the incremental barrels. Ultimately, this causes earnings to accelerate, and this is what analysts mean when they speak of operating leverage.

Investors have already begun placing their bets on this group, clearly taking the same side as the tempered Mr. Bird. XOP is up 19% YTD and shares outstanding have tripled since 2014. Holdings include well-known E&P names like Chesapeake Energy Corp (CHK), Devon Energy Corp (DVN) and EOG Resources Inc (EOG). When all the easy oil is drilled and production starts to slip, prices will have to rise to incentivize drilling and this group will benefit disproportionally.

2. Pay Me While I Wait (AMJ)

Unlike the Boom/Bust nature of the oil and gas E&Ps, the 44 companies in the Alerian MLP Index ETN (AMJ) focus on the more mundane but predictable aspects of the oil business: Storage, Transport and Processing. They are effectively the toll both operators which collect fees from oil companies. They generate significant cash flow and distribute the money to investors in the form of generous dividends. The AMJ represents 85% of total market cap for the group and pays a dividend of 6.9%, one of the highest of any ETF/ETN baskets in the world. By comparison, the widely held iShares junk bond ETF HYG yields 5.5% currently. If there’s a catch, it’s the risk of a dividend cut, though the current quarterly payout of $0.54 is only slightly below the all-time high payout of $0.60 in 4Q 2014. This group is incredibly resilient. The AMJ basket trades at a P/E of 29x and the fund’s annual expense ratio is 0.85%, so it’s not exactly cheap. Still, the 6.9% yield gets my attention.

3. Steady as She Goes (XLE)

When I was a young oil trader working for one of the largest and oldest private commodity companies in the world, Exxon’s head of trading graciously invited me to lunch. Mostly we talked about life, but I do recall a very specific comment: “Adam, once a year we figure out our drilling budget for the next 12 months. Then we put it into action, produce a lot of oil and everyone makes a lot of money.” Translation: Don’t overthink this. Companies like ExxonMobil Corp. (XOM) are slow and steady. They are aircraft carriers that require many miles to change direction or come to a stop. Just follow their wake and you’ll probably do fine. The Energy Select Sector SPDR Fund (XLE) is the largest of the energy ETFs and its expense ratio is just 0.14%. ExxonMobil and Chevron Corp (CVX) constitute a third of the index, while E&Ps represent about 40%. Oil field service and pipelines make up the remaining 25%. The XLE yields 2.8%, and if you simply want exposure without the worry, this is your index.

Energy ETF Vital Stats

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Separation Anxiety (Issue #10.3 – 8/5/16)

Separation Anxiety

Miners Too Far Ahead of Gold

  • Mining stocks have rallied five times more than gold year-to-date
  • Incremental gold demand in 2016 has been driven largely by flows into exchange traded funds
  • Poor profitability among mining companies undermines current valuation
  • Options market offers attractive ways to establish short exposure

Anyone who bought gold mining stocks at the beginning of the year is a hero. The big companies like Newmont (NEM) and Barrick (ABX) are up 127% on average. The smaller takeout candidates, often called the junior miners are up even more –about 165%. No other sector even approaches triple digit returns this year. Granted, the sector peaked in 2011, so investors have had to wait five years for redemption. In addition, many of the miners still sit well below all-time highs, but this year’s windfall feels pretty good. The operative question at this point: How far will they go, or how long will this last?

Newmont Mining CEO Gary Goldberg took a stab at providing an answer during the company’s 2Q earnings call on July 20. As you might expect, he’s bullish.

“Low or even negative real interest rates are making gold an increasingly attractive investment. Concerns about slower global economic growth and weaker domestic employment have forced the Fed to be more cautious about raising interest rates. The markets now anticipate no or at most one rate hike in 2016. Inflation is also trending upward. We’re seeing more money flowing into gold on the back of these trends… global ETF gold holdings have increased by more than 17 million ounces or nearly 40%.”

SA2Mr. Goldberg is correct about the surge in demand from financial buyers, most notably by administrators of exchange traded funds needing to purchase gold in order to issue more units against investor inflows. You can see financial buying accounted for about 13% of demand in 2015, much of which came from central bankers, whereas this year it’s all about the ETF, 336 tonnes worth of buying in Q1. (The supply/demand balance tends to vary by about 10% from year to year, based on demand tracked by Bloomberg from the World Gold Council.) Incremental demand so far in 2016 has been enough to drive the price of gold 28% higher. It’s impressive, but there’s also a disconnect… the mining stocks are up 5 times more. I recognize they have operating leverage… but 5x?

Conscious Uncoupling
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In fairness, companies like Newmont Mining have been particularly adept and lowering costs and paying down debt during the four year gold implosion which haunted them from 2011 to 2015. They’ve shuttered marginal mines and generally brought all-in sustaining costs (AISC) down to $700-800/oz from well over $1,000/oz. In the case of Barrick Gold, net debt has fallen from $10.4B in 2014 to about $7.5B currently. Overall, mining companies have done a good job retooling their businesses to prepare for leaner times, realizing like so many others $2,000 gold wasn’t the slam-dunk markets had assumed.

It’s a very different scene from 2010, when I interviewed then-Newmont CEO Richard O’Brien at the BMO Metals & Mining Conference for Bloomberg Television. He had just wound down the last of Newmont’s hedges (impeccably timed) and proudly announced he did so because investors told him they wanted exposure to gold, not financial wizardry. They certainly got it… albeit in a different way.

Here’s the thing about gold investors: When they buy, they think gold is going to make them rich. It’s not about double-digit earnings growth or cheap NAV, it’s about runaway inflation or the end of fiat currency and only gold will protect them. $2,000 gold? More like $10,000 gold. Take a look at the metrics for the three largest mining companies in the ever popular VanEck Gold Miners ETF (GDX), whose daily average volume of 73M shares makes it one of the most active equity securities in the world.

You Want to Own These?

Q1 Profit Metrics
SA4

The profitability metrics on these companies are AWFUL, and by the way there’s no dividend to speak of because there are virtually no earnings. Obviously investors see something else… I love Goooooooooold.

Okay, I admit an average price to book ratio of 2.09 for the miners in the GDX and 1.96 for the smaller companies in the GDXJ is not unreasonable. It’s neither rich relative to the S&P 500 Index nor to the historical range for the sector. In addition, I fully recognize the appeal of gold against the backdrop of rising sovereign debt due to global money printing by central banks. I will also grant that all this money printing may one day stoke inflation, against which gold should provide a hedge. Fine.

But let me say this: I do not want to own marginally profitable mining companies already up 150-200% YTD on the “hope” gold rallies further. In fact, I want to short them, and the analyst community would appear to agree. Many of the stocks within the GDX and GDXJ are trading at/near consensus targets. They’ve had their run and it’s time to sell. Here’s how we do this:

1. Buy puts on the GDXJ funded by selling calls. I like Sep 50 puts vs Sep 53 calls at even money (both $2.80) with the index at $51.00. This combo give us a little cushion and costs nothing initially.

2. Buy long-dated GDX Nov 29 puts for $1.90 and forget about them. The index is at $31.25 so the breakeven is -12.58% and if the miners break, this option will accelerate quickly (33 delta currently).

3. Short a little Couer Mining for fun at $15.75… it’s up 535% YTD.


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Elephants, Donkeys & Dogs (Issue #10.2 – 8/5/16)

Elephants, Donkeys & Dogs

5 Reasons to Buy Puts Now

  • 19 mini sell-offs in 5 years have generated average declines of 7.45%
  • September is historically the weakest month for stocks since 1929
  • Highly defensive sectors are outperforming the broad market four to one
  • The Volatility Index (VIX) near historic lows means puts options are relatively cheap

Cable news networks have never had it so good. Viewership is through the roof as politics go 24/7 and AC provides refuge from the heat. America has become so enthralled with the election that nothing else seems to matter. Olympics in Rio? I’m still waiting for the buzz. What about Naval Action in the South China Sea, or a Breakthrough in Syria… Nope. Stocks at all-time highs? Hello? In these Dog Days of
Summer I hear nothing but crickets. Donkeys and elephants have stolen the show. I think we’d be wise to distance ourselves from this heard and recognize risk is seldom so singularly focused. Time to buy insurance and protect our capital.

I want to present several charts and graphs to illustrate why I am a buyer of S&P 500 puts. I think they help tell the story more poignantly than words alone. While I recognize the world’s central bankers effectively have our back and will immortally do “whatever it takes” per ECB President Mario Draghi, too many indicators are gnawing away at me, starting with this one:

1. Sell-offs Happen… Frequently

S&P 500 Index

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The S&P 500 Index has experienced 19 sharp declines of 7.45% during the past 5 years, with half of them happening in the past 2 years and generating some particular nasty downdrafts. As you can see on the far right side of the chart, the index is now perched at all-time highs as if poised to produce another “golden arch” –fries not included. I fully recognize the market bounced back each of those 19 times, but I also recognize the index trades at an historically rich 18.4x earnings (assuming $118) and FactSet now forecasts a sixth consecutive quarterly earnings decline come 3Q reporting season. Ask yourself why you are buying all-time highs absent earnings growth. If it’s because the Fed has your back, and you have no place else to go, by definition this picture should make you uncomfortable. You need insurance in the form of puts.

2. Approaching Seasonal Weakness

Monthly Returns Since 1929

Jeff Hirsch and his team at the Stock Traders Almanac have done some excellent work on seasonal tendencies across markets over long periods of time. Among their best known and oft cited observations, the S&P 500 Index typically posts its worst month in September. It has declined an average of 1.1% during September since 1929 and it’s one of only three negative months of the year. This would not be reason enough to buy puts, but in light of valuation and the apparent stalling out at new highs from our previous chart, it’s another reason to play it safe. We are entering the seasonally weakest month of the year, meaning the odds are less in our favor. As we try to smooth out returns and differentiate ourselves from the indexers, we need to be aware of the potential for downdrafts and protect against them. Speaking of safety, look what’s leading performance this year…

3. Awkward Leadership (aka The Last Shall Be First)

Returns YTD

There is only one reason why slow-growing Telecom and Utilities are outperforming the broader index this year by 4 to 1: Dividend Income. They yield 4.4% and 3.1% respectively, which significantly exceeds the 1.9% average for the broader market. Income is a fine reason to own stocks in an anemic low growth environment where the 10yr Treasury yields about 1.5%. However, safety is not indicative of a bull market. Boring consumer staples are so over-owned right now they trade at 23x earnings and yield just 2.5%. In addition, only 60% of the 500 stocks in the index are above their 20-day moving averages, compared to 95% three weeks ago. This tells me fewer stocks are holding us up. When breadth declines and defensive groups are leading, I get uncomfortable about a downdraft.

4. No Trend Whatsoever

Real Clear Politics Polling Average

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The inability of either candidate to breakout from a plus/minus 5% margin of over any period longer than several weeks is highly challenging for anyone trying to deploy longterm capital. There is simply no discernible trend. While we can argue Clinton is good for hospitals through increased government backed funding, Trump would presumably be the opposite. Similarly contrasting outcomes can be made for coal, drilling, multinational tax policy and even defense (On this last point, Trump’s America first orientation might make him LESS tolerant of overseas defense spending than Clinton… how’s that for a mind-bender). My point is markets ABHOR uncertainty and the dynamics of this election are more uncertain than any in recent memory. With still nearly 100 days to go, I suspect there will be enough nervous energy to create more than one unpleasant sell-off in coming weeks.

5. The Crocodile (see the teeth?)

S&P 500 Index vs the Volatility Index

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My thanks to Minyanville Founder Todd Harrison for sharing with all of us his favorite chart depicting “animal spirits.” He calls it the Crocodile chart because of the ominous gaping jaws at the far right. The SPX at all-time highs and the VIX near all-time lows create the image of a croc with its mouth wide open and ready to pounce. Admittedly not very scientific but a great image nonetheless. It reminds us stocks are expensive the volatility is cheap, which brings us to my actionable point.

–> Time to Buy Puts

I like trading options on the SPY, which is simply the S&P 500 Index with the decimal moved over one place to make transactions more affordable. So SPX at 2180 equates to SPY at 218.00. Additionally, I generally buy puts 2 months into the future which are slightly out-of-the money and will accelerate quickly in the event of a decline.

As an example, the September 30th puts struck at 215 cost 2.90 per contract. This is a total dollar outlay of $290 per $21,500 of notional exposure, which equals about 1.3% for 55 days or about 8.5% on an annualized basis.

Think about it. You can carry exposure into a risky time of year with unknowable election volatility and high valuation, or you can spend a small amount of money for peace of mind. For me the choice is clear. Buy puts.

Now go enjoy your August vacation.

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