The Last Shall Be First (Issue #3.3 – 4/29/16)

The Last Shall Be First

21 Shorts to Avoid

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

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

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

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

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

Most Pain…Most Gain

S&P 1500 sorted by Short Interest

LastShallBeFirst S&P 1500 sorted by Short Interest

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

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

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

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

Shorts on the Rise

SI as % Float hits 5yr High

LSBF chart

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

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

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

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

What to NOT to Short

Values as of March 10, 2016

LastShallBeFirst Values as of March 10, 2016

Anchors Aweigh (Issue #3.2 – 4/29/16)

Anchors Aweigh

One Fleet to Own Now

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

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

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

Compelling Value

Key Metrics as of 12/31 (millions)

Anchors Aweigh Key Metrics as of 12_31 (millions)

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

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

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

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

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

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

China Driving Demand for Tonnage

Imports of LPG + Hydrocarbons (000 tons)

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

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

 StealthGas: Too Cheap to Ignore

March 2016 (Bloomberg data)

Anchors Aweigh March 2016 (Bloomberg data)

Keep It Simple Stupid (Issue #3.1 – 4/29/16)

Keep It Simple Stupid

Seven IT Companies Transforming Engagement

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

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

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

Hard to imagine two more different outcomes. While each company responded in real time, one pointed to a solution while the other fumbled the ball. What’s especially poignant is how a former government monopoly beat the pants off a legendary retailer on customer service. The problem… data paralysis Chief Digital Officer Vala Afshar estimates companies capture only 1% of available data, as 90% of the data has been created in the last two years and companies haven’t caught up. We’ve gone well past iPhones tracking you on GPS. Retailers now record your movements within the store. As a result, data transmitted across mobile devices has risen 8x since 2012. Cisco predicts 10-12 fold by 2017.

Mobile Data Explosion


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

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

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


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

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

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

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

Lean Digital Approach

Proactive Value Creation

Keep It Simple Stupid Proactive Value Creation

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

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

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

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

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


Companies Streamlining Enterprise IT

Keep It Simple Stupid Companies Streamlining Enterprise IT

Thank You Uncle Sam (Issue #2.3 – 4/15/16)

Thank You Uncle Sam

How to Maximize your 401(k)

  • Compounding and dividend reinvestment significantly enhance 401(k) returns
  • Outperform after-tax accounts nearly two-fold over long-term holding periods
  • Second quintile dividend stocks offer the best risk-adjusted returns
  • Six stocks to buy now

American illustrator J.M. Flagg created his iconic image of Uncle Sam for Army recruiting posters in 1917. He effectively painted himself wearing a top hat and borrowed the nickname from a legendary U.S. Army meat supplier from the Battle of 1812, whom troops affectionately called “Uncle Sam” for stamping US on bags of rations. Today pork has replaced steak as Washington’s meal of choice, but there’s still one particular 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 Internal Revenue Service Code in 1978, though in true governmental fashion the IRS took another three years to codify treatment and structure for what would become commonly known as 401(k) accounts. By 1983, seven million Americans were on board. Today the number has risen to 55 million and assets top $4.5 trillion, according to the Investment Company Institute.

Now, let’s be clear: 55 million people may sound like a lot, but it’s less than one-third of the working population. Far too many people are ignoring Uncle Sam’s generosity… note the pointed finger. This is red meat for the masses, and everyone has a seat at the table.

401(k) accounts represent the single most advantageous retirement plan available and we should all be participating. Here’s why and how to maximize returns.

For the 2015 tax year, individuals can contribute up to $17,500 of pre-tax income. In addition, companies can make matching contributions, provided the combined total does not exceed $53,000. All earnings which accrue in a 401(k) are tax deferred, meaning no tax is paid until withdrawal, presumably after retirement and therefore at lower rates. Since earnings include interest, dividends, and capital gains, 401(k) returns significantly outperform identical allocations in after-tax accounts. In effect, the government is giving you a loan on all your gains, allowing you to compound the government’s money in the process. Again, this is a very good deal.

To better illustrate the point, consider returns on the S&P 500 Index relative to its Total Return Index, where dividends are reinvested without regards to tax withholding. This is analogous to a 401(k) account. Every time a company in the index pays a dividend, the amount automatically goes towards purchasing additional shares. The Total Return Index assumes taxes and commissions are zero.

Reinvesting Dividends Adds Up

Total Return Index vs S&P 500


ThankYouUncleSam2 Reinvesting Dividends Adds Up

The difference is staggering when seen on the chart above. While an initial investment of $100 in the S&P 500 Index at the beginning of 1990 rose to $580 by 2015, the Total Return Index (TRI) rose an additional 430 percent to $1,010. The reason for the near doubling of performance is twofold: additional shares accumulated over time generate additional return; no taxes are paid on dividend distributions, so more money buys more shares.

Let’s put some real world numbers on this to further prove the point, focusing on the actual 25 year period from 1990 to 2015. We will be very conservative in our assumptions: a.) an individual’s company does not match employee contributions; b.) the IRS maintains its current maximum of $17,500 rather than adjusting upwards for cost of living.

Our base case reflects the actual return of the S&P 500 Index over the 25 year period, including dividend income, but not allowing for any dividend reinvestment. In our 401(k) account by contrast, those same dividends accrue tax-free and are fully reinvested. Plugging actual returns of 8.5 percent and 11.4 percent respectively using Bloomberg data, 401(k) outperformance is self-evident.

Power of Pre-Tax Compounding

S&P 500 Returns (1990-2015)


ThankYouUncleSam2 S&P 500 Returns (1990-2015)

The key here is compounding over time. The same S&P 500 stocks in a 401(k) account produced nearly double the return of 25 years. For all the talk (and effort) to find the next Uber or Apple, buying boring dividend-paying names and reinvesting the proceeds on a tax-deferred basis is a highly profitable strategy.

Now that we’ve got the basics, the question is whether we can further optimize returns through stock selection, and the answer may be yes. The team at Strategas Research looked at the risk-adjusted returns of S&P 500 component stocks sorted by dividend yield. They found risk and reward were maximized when investors bought the second decile of highest yielding stocks (i.e. stocks ranked 61-80% in terms of yield) and rebalanced every 6 months. As their data illustrates, the second quintile produced the highest returns on both an absolute and risk-adjusted basis.

Second Quintile Steals First Place

S&P 500 Index by Dividend Yield (1990-2015)


ThankYouUncleSam2 S&P 500 Index by Dividend Yield (1990-2015)

We are all about maximizing returns, but not at the expense of our sanity. Even in a world of zero commissions, the prospect of buying/rebalancing/reinvesting dividends on over 100 stocks is totally impractical. So as an alternative, we applied the Strategas second quintile approach to the more manageable Dow Jones Industrial Average. The index has just 30 components, all of which pay dividends, so the second quintile totals just six companies.

Backtesting the strategy with Bloomberg Analytics over the maximum period allowable (2000-2015) shows the DJIA second quintile group outperformed the overall DJIA Index by a margin of three to one, returning a cumulative 151% compared to 52%. Additionally, since Bloomberg Analytics can only model dividends paid plus stock appreciation on backward-looking time series, not dividend reinvestment, we would expect actual returns to be higher.

DJIA Second Quintile Dividend Portfolio

As of 12/30/15


ThankYouUncleSam2 As of 12_30_15

For investors looking to replicate our study, or begin putting it to work in their own 401(k) accounts, here’s our methodology:

• Buy the second quintile dividend components of the DJIA as of 12/31.
• Rebalance as of 6/30, and every 6 months thereafter.
• Immediately buy new shares with proceeds from dividend distributions.
• Our study revealed 51% turnover annually, meaning three stocks were typically bought/sold every 6 months.

Semi Hammer (Issue #2.2 – 4/15/16)

Hammer the Competition

One Semiconductor’s Quest to Dominate

  • NXP Semiconductors ranks #1 by sales in its two largest markets
  • Top 10 largest shareholders add to positions in Q4
  • Key executive reiterates Freescale merger synergies
  • CFO to update profitability and growth metrics April 28

“We don’t want to be just number one in the market, we want to be number one and at least 50% bigger than the next guy in the business.”

Strong words indeed, and we admit they catch our attention. We don’t often hear executives raise the bar quite so high, especially in the beleaguered semiconductor industry. Intense competition has compressed operating margins, and research firm IDC estimates growth in 2016 will barley touch 3 percent.

But don’t bother telling Peter Kelly, Exec Vice-President of M&A at NXP Semiconductors NV (NXPI). He’s the man who made the comment at Morgan Stanley’s Tech Media & Telecom Conference in early March. He is also the executive charged with integrating NXP’s recent acquisition of Freescale Semiconductor. The companies merged in December and now control over half the market for secure smart chips used in the auto industry. In that rapidly growing niche, where NXP’s chips work with sensors to enable park assist, automatic braking and lane change alerts, no one else even comes close. NXP also ranks #1 globally in programmable smart chips used on credit cards and inside smartphones to power secure money transfer apps like ApplePay (9.5% of sales). Samsung is also a customer, accounting for 5.5% of sales.

Together, NXP’s dominant auto and consumer franchises account over half annual revenue, estimated at $9.5B for 2016 as the company integrates its Freescale acquisition. This transaction catapults NXP squarely into the middle of the S&P 500 Index, comparable to Mastercard (MA), Lennar (LEN) and Tyco International (TYC).

Still haven’t heard of NXP? You will, and the company is making sure. Nearly the same day Mr. Kelly made his case to attendees the Morgan Stanley TMT conference, several positive developments hit the tape:

• NEC Corp. (6701 JT) names NXP Semiconductors Partner of the Year
• Harman (HAR) teams with NXP to enable vehicle-to-vehicle communication (V2X)
• NXP introduces remotely programmable smart cards which can serve multiple apps
• Drexel Hamilton initiates NXP as a Buy with $102 target (+30% upside)

Wall Street got the whisper ahead of the news, of course. Top ten shareholders all bought shares during Q4 –lots of shares– and critically they are strong-handed buyers with very deep pockets… a CFO’s dream.

Big Names…Big Buyers

Position Change 4Q15

SemiHammer2 Position Change 4Q15


Institutional investors of this caliber buy large blocks because they have vetted the story ad nauseam. Their analysts have inserted themselves into the supply chain and modeled future cash flows. Their portfolio managers have argued multiple opportunities around the table and settled on a select few. Ten thorough investors reaching the same conclusion at the same time speaks volumes.

CATALYST #1: the NXP/Freescale combination creates runway.

First, the combined company will control over 15% of the $26B market for secure, specialized chips used by the auto industry. Second, this market is growing three times faster than the overall semiconductor market according to IDC, 9% versus 3%. Third, the sensor/secure chip architecture in hybrids and driver-assist technologies has significantly higher margins than traditional logic chips, in some cases by a factor of four. Fourth, these smart vehicles require double the number of chips, a total of $200 per vehicle. Fifth, added scale fosters long-term partnerships with key suppliers, providing added earnings visibility for NXP investors.

In addition to reiterating $500M in merger synergies (20% gross margin expansion and 80% cost savings) Mr. Kelly shared the following with attendees at the Morgan Stanley event:

“As soon as we announced the deal, the big OEMs were all over us straight away. They just see this as hugely positive. For them, they’re making a big investment in you as a partner. They know they have to work with you as a partner for 10-15 years. They are delighted to have a big company to work with.”

We will likely hear more from Mr. Kelly on April 28 at the company’s first analyst day since the merger. He told us to expect detail from CFO Dan Durn as to “what our growth targets are, what our gross margin targets are, what our operating margins are… and more importantly how we get there.” We will eagerly await those details. Meanwhile here are some of the figures currently forecast by the Street, including NXP’s closest competitors for both auto and mobile segments (60% of pro-forma sales for 2016):

Key Metrics Beat Key Competitors

Trailing Twelve Months


SemiHammer2 Trailing Twelve Months

CATALYST #2: Rising demand for NXP’s secure smart chips which drive e-commerce on mobile devices.

While mergers grab headlines, STX has an equally compelling opportunity to expand its near-field communication chip business (NFC) on mobile devices through major agreements with Apple, Samsung and Xiaomi.

NXP creates secure chips in smartphones which enable tap-to-pay transactions, think Starbucks lattes with a tap of your phone at the checkout counter. This mobile division was equal in size to Auto prior to the Freescale merger ($1.3B annual revs), and is growing even faster at 13%. The deal with ApplePay accounts for nearly a tenth of NXP revenues, and a recently announced expansion with Xiaomi further enables public transit payments throughout China.

Essentially, these are the next gen chips which first appeared on credit cards in the 1990s as a secure alternative to magnetic strips. That transition solved fraud issues, and now internalizing payment within the phone increases flexibility. Since the phone is connected, chips can be updated remotely, unlike chip enabled cards which have to be replaced. Related applications like electronic passports present additional upside.

In the case of Xiaomi’s new transit app, the goal is to transition 400M users of disposable transit cards to tap-to-pay technology. It’s just one of 108 NXP customers identified by Bloomberg. Based on company filings, Bloomberg Intelligence quantifies such near-field communication (NFC) opportunities as a potential 98.5% CAGR market through 2020, which would still put mobile payments at just 7.1% of total.

Positioning for Growth

Tap-to-Pay Upside

SemiHammer2 Tap-to-Pay Upside

25 analysts cover NXP, 23 of whom rate it a Buy. Collectively, they forecast 35% upside over the next 12 months (average target $104). We agree with their estimation, and we believe 13.6 times earnings is far too cheap given the glide path.


Buy the Buyers (Issue #2.1 – 4/15/16)

Buy the Buyers

Twelve Banks Devouring the Competition

  • Select regional banks driving superior results through strategic M&A transactions
  • Most active acquirers operating far from large, concentrated banking centers
  • Serial acquirers delivering higher net interest margins and earnings growth
  • Strong outperformance in spite of powerful head winds for the sector

George Gleason bought his first bank in 1979 at age 25, becoming both employee #13 and Chairman of a $28 million lender with five branches across rural Arkansas. Dozens of acquisitions later, his Bank of the Ozarks, Inc. (OZRK) is still buying and consistently ranks as one of the most profitable regional banks focused on traditional Main Street lending. Since 2010 alone, he’s added $6.6B in assets. His current bid for C1 Financial (BNK) will expand the franchise into southern Florida, adding an additional $1.5 billion in assets.

American Banker named Gleason Community Banker of the Year in 2010, citing consistent shareholder return and superior profitability. Operationally he focuses on three key drivers: net interest margin; asset quality; efficiency. Recently reported results for 4Q 2015 tell the story. Bank of the Ozarks’ NIMs of 526 bps rank well above the industry average of 337 bps, and annualized charge-offs total just 0.17%, meaning the bank writes down just 17 of 1,000 loans.

The stock has recently suffered from the market sell-off, as well as a lawsuit brought by shareholders of current target C1 Financial, who argue OZRK’s purchase price is too low. Even so, shares have trended higher with the announcement of each transaction. Since the beginning of 2011, shares have appreciated 246%, seven and a half times the Keefe, Bruyette & Woods Index of regional banks.

Growth & Gains

M&A Driving Outperformance

BuyTheBuyers2 M&A Driving Outperformance

While a master of merger integration, Gleason’s roll-up strategy is hardly novel. BofA, Citigroup, JPMorgan and Wells Fargo can all trace the size of their current footprints to multiple acquisitions made since 1990. In the past three years alone, twelve regional banks have kept M&A advisors particularly busy, each buying an average of $265 million in assets every 9 months.

Busy Bankers

Top Consumer Bank Acquirers (2013-Present)


BuyTheBuyers2 Top Consumer Bank Acquirers (2013-Present)

What’s particularly interesting about this group is its ability to post consistent growth and profitability while integrating multiple banks into their own established businesses.

• Net interest margins, the difference between a bank’s return on capital and its cost of capital, are significantly wider than the 94 banks of the S&P 1500 Bank Index (3.75% vs 3.37%).
• Earnings growth has exceeded the averages, both for the past 3 years and based on 2016 estimates (16% vs 13% and 14% vs 9% respectively). We also note this year’s estimates exceed the broader S&P 500 Index earnings forecasts by 2-3 times.
• Return on Equity figures are comparable to those of non-acquisitive banks, indicating transactions were generally accretive to earnings and therefore positive for shareholders of the buying banks. As Gleason commented at the C1 Bank acquisition announcement, “We strive to be an industry leader in providing best-in-class customer experience and operational efficiencies.”

Operational efficiencies are the operative words here. Streamlining procedures and integrating software gets very expensive, so does added regulatory compliance since 2008. Former American Banker Association President and two-term Oklahoma Governor Frank Keating told me Dodd-Frank costs the average Main Street bank 17 percent of operating profits. So the fact these twelve banks have been able to deliver superior earnings growth and maintain ROE while integrating multiple acquisitions speaks volumes. It also explains why they trade at a slight premium, in terms of price to tangible book value (1.83x vs 1.64x).

These regional banks have found a formula for earnings growth which eludes their larger money-center brethren. It’s a combination of strategic acquisition at the right price, organic expansion in niche markets, and rigorous attention to costs/efficiencies. Their proven ability to generate superior growth without sacrificing return on capital is all the more impressive considering two key facts:

1. Net interest margins for the industry as a whole sit near the lowest level since 1985, reflecting both a challenging environment near-term and a soft outlook into 2017

2. Bank stocks tend to lag NIMs by up to five years, as bond markets adjust faster to perceived future conditions than real world bankers can originate new loans (see below)

Powerful Headwinds

Profit Margins and Time Lags

BuyTheBuyers2 Profit Margins and Time Lags


Again, these banks have outperformed in spite of powerful headwinds. Their NIMs are rising and so are their stocks, which is why investors are paying a higher multiple of book value. As large money center banks continue parking excess reserves at the Federal Reserve to earn 25 bps, these strategic buyers are aggressively deploying capital to increase their footprints. They are building their businesses. They are the one slice of the banking sector to own now.

Smokey the Banker (Issue #1.3)

Smokey the Banker

Nine Stocks with 10% Growth at 10x Cash Flow

  • Central bank balance sheets still 3-6 times pre-2008 levels… and rising
  • Recent actions by BoJ and ECB exacerbate deflation
  • Financial debris piling up creates incendiary conditions
  • Protect capital in proven Growth at Reasonable Price (GARP) strategy

Quail plantations cover south Georgia’s pine barrens for miles. Hours pass as you make your way through sage brush and red clay, steering your horse around pines taller than the sky. It’s an lyrical place and I found myself transported. Strangely though, something our huntsman said about annual shrub burns in March led my mind back to the canyons of Wall Street and rip tides of Washington. Allow me to explain.

Longleaf pine forests overhead and grasslands afoot sustain native quail populations which once stretched from Virginia to Florida, as far east as Texas. They survived for centuries through diversity and resilience. In addition to providing habitat for up to 300 separate plant species and 60 percent of the region’s amphibians and reptiles, their seeds could withstand the heat of regularly occurring forest fires, sometimes only sprouting because of heat. These boom/bust cycles occurred regularly, clearing the forest floor from debris and providing ample opportunity for plants to regenerate… ultimately creating more suitable habitat for quail and other wildlife.

Today this ecosystem covers just three million acres across the southeast, down from an estimated 90 million acres before settlers began arriving 300 years ago (The Smithsonian). In addition, a stated “zero tolerance” policy against forest fires by U.S. Forestry Service mascot Smokey the Bear means forests don’t purge themselves naturally, creating an unnatural build up of dead wood which has contributed to a 19 percent increase in fire season length over the past 35 years (Nature Communications study, July 2015).

As we rode across fields where nature still rules, I was stunned by the now fire-free example presented by global asset markets. Central bankers want no part of cyclical downturns. Fire is something they now seek to avoid at all costs. Their artificial buying has contorted rates into negative territory past the point of recognition. Smokey the Bear meets Janet Yellen. Zero tolerance meet Zero Rates. Again, I digress.

Georgia’s plantation owners are working overtime to rebalance and replace these vast forests, often partnering with local institutions like Auburn’s School of Forestry & Wildlife Sciences and the Tall Pines Conservancy. As my guides explained, the process begins in March and April, when forestry wardens grant permits to conduct controlled burns on private land. Fire eliminates dead wood, consumes oak saplings which starve ground plants of light and produces heat which open spores and seeds. Within weeks, green shoots emerge.

By the second season, a canopy of broom sage hovers four feet above soil no longer scorched by fire, teeming instead with insects. It’s the perfect environment for quail to move in and begin brooding. They are shielded from hawks circling above, while surrounded with ample food for their chicks on the ground. As July arrives the birds will begin exploring corn and sorghum patches farther afield, feeding on an abundance of seed from newly sprouted crops. Come November, they’ll circle fields in coveys of up to 30, relying on one another to fend off predators. Many will survive for several years, though a few will get paired with bacon, as was the case on our particular weekend.

My time in Georgia revealed the modern quail plantation is about restoring as faithfully as possible the natural lifecycle. Full-time staff with forestry degrees serve as caretakers of the land, facilitating blossoms and burns… booms and busts. Their six to ten thousand acre parcels attempt to duplicate what happened for centuries before the advent of roads, homes and businesses. If only the Fed could shift its annual policy conference from the rivers of Jackson Hole to the pine groves of south Georgia…

To the Fed’s credit, it stepped into the abyss of 2009 when banks and private institutions ceased to function. The Fed provided a bid as the lender of last resort and prevented a full-scale meltdown. But as former Dallas Fed President Richard Fisher offered on CNBC mid-January, “We at the Fed brought demand forward by several years by keeping rates so low for so long.” Put another way: We prevented the burn, and now it’s a tinder box.

Like Smokey the Bear, they’ve made clear no fires are allowed… controlled or otherwise. In the words of ECB President Mario Draghi, “Whatever it takes.” He’s not alone. In January, Bank of Japan governor Haruhiko Kuroda lowered the rate paid on excess reserves posted by banks at the BoJ to negative -0.1 percent. Not only is Mr. Kuroda disallowing the removal of debris from the forest floor, he’s imposing a penalty if anyone picks it up.

The logical consequence of increased debris is a much hotter fire, and we may well be stacking the wood past the danger point. Assets held by the four largest central banks outside China (BoE, BoJ, ECB, Fed) have risen fourfold on average since 2000.

Debt Pile

Central Bank Asset Growth


SmokeyTheBanker2 Central Bank Asset Growth

Another recent policy adjustment proves troubling. On January 27, The Federal Reserve released its latest outlook and chose to include some new wording about “monitoring markets.” Smokey, put down the binoculars. The Fed already has a dual mandate, assigned by Congress in the Reform Act of 1977, which states explicitly “the goals of maximum employment, stable prices, and moderate long-term interest rates.” Adding this market-facing mission only increases the Fed’s already interventionist bias. Again, no chance of a natural burn on Chair Yellen’s watch.

One final thought about fires and barking dogs: they wake us up. When a fire erupted inside the walls of my Georgia host’s home months earlier, he was alerted by an otherwise calm labrador retriever. The dog growled at the walls, barked until he was heard and wouldn’t leave until the children were out.

China’s 48 percent implosion since May is our barking dog. For six years we have laid comfortably in our beds as Zero Interest Rate Policy (ZIRP) by the world’s central banks have pushed otherwise responsible investors into inappropriate assets father afield. No longer. The current correction reflects a reassessment of risk by global asset managers. Where the bankers failed to clear the floor of debris, asset managers are now pruning proactively, and they’re not done cutting. The limbs have gotten long, and S&P 500 Index offers little value at 17 times earnings, specially given four consecutive quarterly earnings declines.

As a result we need to find a brush-free clearing for our assets, as well as some blue sky overhead. We turn to our friend David Herro of Harris Associates, named Fund Manager of the Decade by Morningstar in 2010. David is soft-spoken, thoughtful and precise. His stock selection process begins with a timetested screen he runs periodically to identify growing companies with little debt, trading on the cheap:

• Price to cash flow less than 10 times
• Net Debt to cash flow less than 2 times
• Return on Equity (3-yr avg) at least 13.5 percent

89 companies in the S&P 500 Index meet David’s criteria, and as he notes, stock screens are a place to begin, not an end unto themselves.

To narrow the list, we added two more conditions: Projected earnings growth in 2016 of at least 10 percent and positive earnings revisions during the past 60 days. Eight names fall off the list, proving the combination of 10 percent growth at less than 10 times cash flow is difficult to find. As fire risk rises around us, these are the types of places where we intend to seek refuge for a portion of our assets.

SmokeyTheBanker2 Price_Cashflow, NetDebt_Cashflow, ROE, EPS

Matrix Goes Mainstream (Issue #1.2)

Matrix Goes Mainstream

Six Data Mining Companies Watching You

  • Retailers employing same data mining techniques as NSA to drive growth
  • Data Management’s mandate has expanded fromBiz Intelligence to Predictive Analytics
  • Venture Capital investments in Artificial Intelligence setting new records
  • Target’s vast data project provides a window into the future

“You look surprised to see us again Mr. Anderson. That’s the difference between us. I’ve been expecting you.” -Agent Smith, The Matrix

From Matrix to Minority Report, Avatar to Ex Machina, Hollywood keeps churning out conspiracy stories about big data, even as the rest of us voluntarily upload everything from location to likes… and retailers can’t get enough of us.

Take Target for example, where an app-based coupon program called Cartwheel has lit a fire under 25 million shoppers. The more you buy, the more it learns about what you like. The customized deals and discounts just keep coming. Scary? Hardly, more like manna from heaven.

We recently got the inside view on Target’s (TGT) data-driven shopping experience from man who designed it, Chief Marketing Officer Jeff Jones. He refers to customers as guests, and his centralized data collection hub the Center for Guest Excellence. We had the pleasure of interviewing him at J.P. Morgan Masters‘ Series in New York.

“The mobile phone is the most powerful shopping device ever created,” Jones tells a group of over 100 marketing professionals. To illustrate the point, he describes Target’s smartphone app, which directs people around the store to locate products, even maps their most efficient route for an entire shopping list. Out of stock? Not when the app sources it from another store and ships it to your home overnight.

Indoor mapping is made possible through a partnership with a company called Pointe Inside, while Target’s Cartwheel app was developed in-house. Both offer a glimpse into how the mega-retailer uses mega amounts of data to envelope shoppers into what’s become the Holy Grail of retailing: an integrated omni-channel experience (industry jargon for fully integrated, where customers don’t distinguish between digital and physical shopping, and stores double as distribution centers for online orders).

Think of Target’s Center for Guest Excellence as a giant sieve which funnels every conceivable piece of data into one central location for realtime analysis. Purchases, complaints, special requests –even intangibles like mannequins placement– are logged and analyzed to improve a guest’s experience. Ultimately, Target is indifferent between a sale in-store versus a sale online. They key says Jones, is creating a “seamless, excellent experience.”

“The dream is people would come to, but that’s not where it happens. Social platforms like Facebook are so pervasive… digital is now 51% of our ad spend. People go to Pinterest to figure out how they want their home to look, then they come to Target. It’s why we’re putting Buy buttons in posts.”

Jones previously served as CMO at The Gap (GPS), and soon after joining Target he embedded the retailer’s engineers at Facebook (FB). His goal was to foster collaboration on how to better identify individual preferences, and then direct the right merchandise at the right time to the right person. Data has become so critical to Target’s mission that every managers’ meeting begins with a review of real-time customer activity. In fact, each employee receives a morning email highlighting three critical trends gleaned from guest data the day before. The read-thru rate is over 90 percent.

Jones approach has put Target on the cutting edge of retail, but a new report from Forrester Research estimates between 60 and 73 percent of data available to large enterprises goes unused. It’s why VC funds like Data Collective, Bloomberg Beta, Khosla Ventures and Lux Capital have invested nearly $1B in Artificial Intelligence (AI) startups since 2010, according to data collected by CB Insights.

MatrixGoesMainstream2 Artificial Intelligence Global Quarterly Financing History

Former Apple (AAPL) and Pepsi (PEP) CEO John Scully saw the opportunity early on and founded Zeta Interactive in 2007. So did eBay (EBAY) co-founder, Peter Thiel, whose privately owned Palantir Technologies was most recently valued at $15B. Here’s how the company describes itself on it’s webpage:

We’re focused on creating the world’s best user experience for working with data, one that empowers people to ask and answer complex questions without requiring them to master querying languages, statistical modeling, or the command line. To achieve this, we build platforms for integrating, managing, and securing data on top of which we layer applications for fully interactive human-driven, machine-assisted analysis.

Data analysis on the scale employed by pioneers like Palantir, and customers like Target is a multifaceted task which requires massive storage and supercomputer-like power. In broad terms, the industry can be divided into three primary categories:

• Data Management (DM) gathering, scrubbing and organizing metadata
• Business Intelligence (BI) processing data and gleaning insight
• Predictive Analytics (PA) using data to anticipate future activity

Large amounts of data require significant plumbing… vast holding tanks for storage and interconnected pipes for transport. Adding more data is not as easy calling Cisco and purchasing another server, or even Amazon Web Services and renting more cloud space.

For anyone who remembers plugging data into dBase back in the 90s (my first job out of college at Merrill Lynch), we’ve come along way. Data strings are now so dense and cumbersome they require specific solutions. The primary architecture used to manage metadata is called Hadoop, an open source Javabased framework created by two engineers in 2006, and named for the toy elephant belonging to one of their sons. In case you think calling it Hadoop sounds silly or belies its importance, IDC values the market for Big Data at $122B.

Forrester describes Hadoop as “mandatory” for any enterprise looking to identify actionable strategies based on advanced analytics on large amounts of data. Its three primary components include a distributed file system (HDFS) which distributes large data blocks across commodity machines to maximize bandwidth, a resource management platform (YARN) which minimizes stress on any one CPU or server array and a compression program (MapReduce) to speed up processing.

Forrester ranks privately held Cloudera as the #1 Hadoop pure play in its 1Q 2016 report, followed closely by publicly traded Hortonworks (HDP). Other top rated companies include MapR and Pivotal Software, though like Cloudera they too are private. Many of these companies are less than ten years old, and while they are growing sales 40-50 percent annually, most are not yet profitable.

Early VC investors are effectively banking on data mining as the next core driver of enterprise marketing strategy. As John Sculley told me on BloombergTV. “This is the next big thing. It’s where I’m placing my bet and why I’ve hired 60 software engineers.”

Once enterprises have installed Hadoop across their networks to gather customer data, they can begin to analyze it with a host of products broadly described as Business Intelligence (BI). Author of the AtScale Blog Bruno Aziza, describes BI as the point at which company employees pivot from being “knowledge workers to knowledge seekers.”

Gartner published its annual 2016 Magic Quadrant for BI the first week of February and only three companies of 24 made the coveted leaders’ box: Microsoft (MSFT), Qlik (QLIK), Tableau (DATA). This year marks Gartner’s 10th annual report, and it has become the document of reference for buyers of BI technology. To make the so-called magic quadrant, companies have to demonstrate both completeness of vision and ability to execute.

Tableau pioneered the concept of converting multiple data sets into straight forward charts with a its dragand-drop desktop dashboard (demo at: Tableau’s software enables any information tracked by an enterprise (product sales, web traffic, store visits, etc) to be charted and compared across multiple factors with a few mouse clicks. Programmers call this visualization, and the goal is to empower marketing execs with tools to spot trends in realtime.

As an example, Target’s CMO Jeff Jones mentioned how sales associates reported 2-3 fold sales increases when certain items were featured on mannequins. Some further noted how mannequins placed in specific areas attracted more attention then others, driving additional sales. Data visualization would take all that information and create a map of the sales floor, illustrating optimum mannequin usage and placement. Charting over time might reveal further insights, like different traffic patterns on different days. Mannequins could be shifted after hours to maximize expected patterns for the following day.

Not surprisingly, Tableau’s consistent 90 percent gross margins are among the highest in the entire software sector, but growth has halved to 30 percent as competitors have entered the market.
Specifically, Bloomberg Intelligence BI analyst Mandeep Singh identifies fellow Gartner Magic Quadrant leaders Microsoft Power BI and Qlik Sense. Amazon (AMZN) and (CRM) have also introduced their own BI solutions, QuickSite and Wave.

Critically, these newer entrants are taking business intelligence a step further, analyzing changes over time in order to generate forecasts about the future. Its called Predictive Analytics (PA) and its the latest evolution of data analysis. Other companies making the jump to more predictive software capabilities include Apigee (APIC), Splunk (SPLK), Alphabet (GOOGL) through a series of acquisitions and Microsoft via its Cortana Analytics acquisition.

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.”

Industrial manufacturers like GE have already joined retailers like Target in making a big push into predictive technologies. It’s part of the $517B IoT market, where machines loaded with sensors push data to a central hub and adapt to changes without human intervention. GE intends to triple revenue at its PA software subsidiary Predix to $15B by 2020. Per Mr. Rana’s calculation, that would make GE a global top 10 software company, competing directly with IBM and SAP.

Bottom Line: Access to data means every major enterprise looking to grow sales must become a software company. No wonder summer camps teach code.

MatrixGoesMainstream2 Data, Gross Margins, Sales

High Yield Now (Issue #1.1)

High Yield Now

Four Bond Funds Too Cheap to Ignore

  • Implied default rates suggest 20% of energy/metals/mining companies will file Ch. 11
  • Excessive pessimism has widened HY spreads to 800bps, exceeding recessionary norms
  • Strong U.S. payrolls growth consistent with expansion not recession
  • HY offers compelling deep value opportunity

Dr. Ethan Harris of Bank America Merrill Lynch is my kind of economist… pedigreed, top-ranked and totally normal. He once confessed to me in a commercial break at BloombergTV he found my co-anchor’s “multi-syllable words way too confusing.” Last month he told CNBC viewers worried about China to “take a deep breath and relax… they only buy 1 percent of our GDP… stuff over there doesn’t exactly say Made in America.”

Dr. Harris manages the global economic research team at BofAML, and since Institutional Investor has ranked him #1 multiple times, we pay particular attention when he changes his view. Recently, Ethan has raised his estimate for the probability of recession in the U.S. over the next 12 months to 20 percent, so did Ellen Zentner of Morgan Stanley.

While less alarming than the 40 percent probability cited the following day by Deutsche Bank economist Joe Lavaorgna, R-word anxiety has compressed the spread between 2-yr and 10-yr government bonds to the lowest in eight years. Long-term growth expectations have fallen so significantly, traders only demand an extra 113 basis points of return for 2026 compared to 2018. That’s the kind of malaise we witnessed in 2008! Sorry Ethan, but no wonder economics is dubbed the dismal science.

Bond Bummer

2-10 Spread U.S. Treasuries


HighYieldNow2 2-10 Spread U.S. Treasuries

Admittedly, we’ve seen The International Monetary Fund and World Bank lower growth forecasts repeatedly over the past twelve months, though their pronouncements are hardly recessionary. Each institution still sees global growth climbing 2.9 to 3.1 percent, with the U.S. likely averaging just above 2 percent. In fact, not one of the 71 strategists tracked by Bloomberg forecasts negative GDP in the next two quarters, traditionally the definition of a recession.

So by going against the grain, Messrs Harris and Lavorgna are either dead wrong, providing cover for themselves in case we do enter recession, or possibly they are just early.

For clarity we turn to the labor market, which typically peaks 18-24 months ahead of recessionary downturns. We’ve charted the year-over-year change for monthly non-farm payrolls to illustrate the point. Recessions are identified by shaded areas. Severe labor downturns preceded all three recessions, which is not the case currently. January non-farm payrolls rose 1.90 percent, consistent with the 6-month average of 1.97 percent. If recession were in the offing later this year, we’d likely already have seen a steep decline in job growth.

No Downturn…No Recession

Non-Farm Payrolls Still Rising 2%


HighYieldNow2 Non-Farm Payrolls Still Rising 2%

The National Federation of Independent Businesses provides additional comfort about continued labor market strength. It’s monthly survey of 1,400 geographically diverse firms across multiple industries indicates 29 percent of respondents have positions they are unable to fill, a six-month high. Additionally, 11 percent plan to hire additional workers within the next year, consistent with the 6-month moving average of 12%. If business owners are optimistic about hiring, in spite of having to pay 2.5 percent more in hourly wages per the January Jobs Report, we think investors should be more optimistic about the economy. Instead they are running scared.

This fear is most evident in the high yield market, where falling energy prices have gutted the energy sector and widened spreads across the board as if wholesale recession were a foregone conclusion.

Since the best outcome bond investors can expect is repayment in full and coupons along the way, they are notorious for fleeing a fire before there’s smoke. Strategas Research Head of U.S. Fixed Income Tom Tzitzouris explains:

“Defaults are rising and spreads should rise too, but the pace in Jan was a bit too fast for the rate of economic and credit decay. Above 700 basis points, high yield spreads signal a recession. Above 750 they are starting looking cheap. Current spreads at 777 imply a 6.25% default rate… high for a non-recession calendar year and almost 2% above longterm averages.”

Translation: The high yield debt market is oversold and should be bought.

And here’s the key…

Weakness in energy is skewing the entire high yield market. Energy accounts for just 16 percent of high yield issuance but could potentially account for 53 percent of total defaults this year, provided JPMorgan is accurate and one in five energy companies files Chapter 11. Add the related metals/mining sector and the number rises to 71% (J.P. Morgan Debt Monitor).

Never before have one-fifth of America’s energy, metals, and mining companies defaulted in the same year. JPM recently initiated this forecast to present a worst case scenario. In fact, it’s the only way to arrive at an overall HY default rate of 6 percent, since all other sectors will likely see the same sub-2 percent rate of the past several years.

To Tom’s point, spreads above 750 bps imply defaults above 6 percent, and 6 percent is only achievable if energy, metals and mining implode at rates never before witnessed. At these prices, buyers are being well compensated for the risk. We like high yield here.

So THANK YOU nervous bond investors for throwing away your perfectly good bonds. Your fear presents a value opportunity, and while we could certainly buy individual issues, we will opt instead for the diversification of exchange traded funds (ETFs) which invest in a basket of bonds from HY issuers.

Bloomberg lists 33 high yield ETFs, including the two largest and most liquid: iShares HY Corporate Bond ETF (HYG) and SPDR Barclays NY Bond ETF (JNK). We will not consider these two however, as their energy exposure 9.5 and 10.9 percent respectively. Instead we focus on several others with lower exposure. They are all diversified, provide reasonable yield and meet minimum liquidity requirements. In addition they are down on average only 1-2 percent this year, implying reasonable safety compared to stocks.

HighYieldNow2 Yield Energy Cost table