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The Weekly Summary


So far, so good. Unlike last quarter, investors are paying attention to the fundamentals this earnings season, giving most BMR stocks a healthy buzz. While a few reports we thought were fairly decent earned an icy shoulder, on the whole the numbers have been good enough to take our portfolios up a little more than 1% in the past week.


The contrast to 3Q18 is remarkable as well. A year ago, some of the biggest companies on Wall Street were leading the entire market down as giant after giant stumbled on sales, guidance or both. Now, however, investors are more willing to tolerate sluggish results as long as management can provide a compelling argument that better days are waiting a season or two ahead.


After all, the foreseeable future is where stocks do most of their real work . . . no matter how recent, trailing numbers are history. As long as we can anticipate a brighter tomorrow, we'll see buyers outnumber sellers. Who would sell a stock knowing that it will be worth more soon? Not us.


And the numbers are stacking up fast now. Between now and Tuesday morning a full six of our companies are scheduled to file their quarterly reports, and after that the week really gets crowded. With that in mind, much of this Newsletter is all about getting you all the detail you need to get through the next 36 hours, without overloading you with extraneous detail or far-future projections. Focus. After that, we'll have the next wave of Earnings Previews for you to digest, and a week from now the calendar will start to thin out a little again.


Don't forget the Federal Reserve will be meeting on Tuesday and Wednesday, so while earnings may drive individual stocks, the market as a whole may be a little more hesitant than usual. Most people expect a rate cut at this point. The real question is whether the statement will include the critical phrase "act as appropriate" that signals continued willingness to keep rolling rates back from here. Nobody knows. In theory, as long as inflation remains below 2%, the Fed will keep cutting, but Jay Powell and team have shifted their posture before.


There’s always a bull market here at The Bull Market Report! Gary Jefferson is back with fresh evidence that all the "recession" talk is just hot air while The Big Picture backs him up with hard figures on how well domestically-focused U.S. companies are holding up in the trade war. If you're not an exporter, you might not even notice a year of tariffs. That's good news for many of our stocks.


Speaking of our stocks, we're updating you on ZScaler's continued promise as well as Salesforce.com, Square, Twilio, Dollar Tree and Workday. Don't forget the Earnings Previews if you want to get ahead of what Spotify, Alphabet, Akamai, Welltower, Vornado and Shopify will tell us tomorrow and Tuesday morning.


Finally, The High Yield Investor brings back a few old friends that are worth a second look. The inverted Treasury curve made us cut these stocks from our coverage universe. With the Fed spending $60 billion a month to repair that situation, these companies can make money again, so our initial sell thesis no longer applies. We're watching them closely but are cautiously optimistic.


Key Market Indicators



BMR Companies and Commentary


The Big Picture: Never Mind The Exports


Now that we're two weeks into the 3Q19 earnings cycle, we have a much better view of where strength and weakness are distributed across the market as a whole. Yes, overall profit is still tracking close to 4% below last year's levels even though sales are actually up about 3%. But the global business environment hasn't deteriorated. It's only gotten more expensive to serve that essentially vibrant demand for everything from raw materials to the most intricate consumer devices ever developed.


The global economy has decelerated without falling anywhere near outright recession. Margins have receded a little as inflation remains mild but persistent. In the grand scheme of things, it's a slow season like most others we've survived over the past decade.


And it looks like the real year-over-year drag is all about the trade war. Companies that do more than half of their business in the United States are holding up extremely well. Those selling U.S. products and services to U.S. customers barely register any impact from trade policy. At worst, earnings on that side of the market are tracking 1% below last year's levels, which is roughly what we'd expect when inflation and GDP growth are so close together.


But then there are the companies that rely on overseas markets for more than half of their revenue. They're bleeding, with earnings so far coming in 9% below last year. We're looking at Big Oil, other Commodity companies and quite a few Technology component makers here. If you rely on selling to Asia and other global manufacturing centers, you're having a bad time.


Most of our recommendations are in the stronger domestic-oriented group. Smaller Technology companies, for example, have little to fear from shifting trade policy because their services never cross international borders. The only real challenges they face are from enterprise-level customers pausing their own big budget decisions in large enough numbers to throw off the sales projections. Then there's our Real Estate group, which by definition is all about physical presence on the ground. While these companies may rent to foreign entities, the business still happens right here.


Moving up the food chain, the biggest BMR companies focus on domestic customers so any trade war impact has been extremely limited. It's worth pointing out that even though Amazon was a bottom-line miss this quarter, its numbers don't count toward the "foreign exposure" side of our math today. (Only 25% of all Amazon revenue comes from overseas.) Apple, on the other hand, is the main culprit with international sales accounting for nearly 60% of its money . . . while we still love the company, its very size and reach make it vulnerable to shifts in the global landscape.


And we'd much rather weigh a strong domestic economy against hiccups in international markets than the opposite scenario. Strength at home has been both persistent and steady, if occasionally a little less robust than we'd like. Trade has been an external cloud that will evaporate the minute negotiators make a deal. This won't last forever. Once we see cross-border clarity, that 9% earnings decline will flip back to year-over-year growth we can all appreciate.




ZScaler (ZS: $43, flat last week)


ZScaler has had a very up-and-down year. The stock is currently up 8% YTD, but was much higher, having cracked the $80 mark over the summer. The stock has since shed around 50% of its value, and we believe it to be oversold.


The company offers cloud-based Cybersecurity. And while it’s true this is a crowded space, ZScaler is an industry leader, offering various types of security measures to clients. Software-as-a-Service is expected to grow 15% per year, becoming a nearly $150 billion market by 2022. With companies increasingly-reliant on cloud-based solutions, ZScaler’s services are more in demand than ever.


Revenue growth for the company has been above 50% over the past three years, with total revenue increasing from $80 million in 2016 to over $300 million last year. Gross margins have also shot up 7% over that time, to 80%. The company is putting the pedal to the metal when it comes to sales and marketing, upping its spend to acquire new customers. They recently scored a win with an announced CrowdStrike integration. There will likely be more of these to come.


BMR Take: Gartner has rated ZScaler #1 in the industry when it comes to completeness of vision, for the past eight years in a row. There are many competitors who focus on one type of cybersecurity (some that are members of the BMR portfolio), but ZScaler is a holistic, cloud-based solution. With strong fundamentals and management stepping up its sales and marketing efforts, we believe ZScaler is due for a bounce.





Dollar Tree (DLTR: $115, down 2%)

Dollar Tree is a company many were writing off at the beginning of last year. After facing numerous challenges integrating the Family Dollar brand, some analysts were growing tired of the stock. But not us. We’re glad we stuck with this fundamentally sound retail outlet, as the stock is up nearly 30% YTD, and is riding plenty of positive tailwinds as the year closes out.


With Dollar Tree, we focused on the fundamentals and were right to do so. 2Q19 was strong, with revenue coming in at $5.7 billion for a 4% YoY gain, and EPS of $0.76 beating consensus estimates by a penny. Perhaps most importantly, both the Dollar Tree and Family Dollar brands turned in 2.4% same-store sales growth, which proves that the Family Dollar redesign is working. Management made some tweaks based on what was working for Dollar Tree in the past, and now Family Dollar is back on track.


Dollar Tree is that rare retail stock that acts as a defensive play against an economic downturn. In fact, analyst firm Bernstein recently picked Dollar Tree as a stronger defensive play than chief competitor Dollar General.


BMR Take: Dollar Tree has been thriving as Family Dollar turns around, and things will continue in this vein. Even if the economy takes a hit, customers who might not otherwise shop for bargain discounts flock through its doors. Plus, this is one retail outlet that isn’t negatively impacted by the rise in e-commerce shopping (specifically through Amazon). Dollar Tree is a good means of diversifying into the retail space.





Salesforce.com (CRM: $150, up 5%)


It’s been a bumpy ride for Salesforce all year, however the stock is up 8% YTD and we believe it can get back above the $160 mark by year end.


The stock is down about 15% from its 52-week high, and that spells a buying opportunity. This is a company that has grown 20% a year over the past decade, and being the #1 CRM software, there is every reason to see that type of growth continuing, especially as the market continues to expand globally, with more and more companies relying on cloud-based CRM services.


2Q19 wasn’t just good, it was great. Revenue of $4.0 billion provided a 22% YoY gain, and EPS of $0.66 beat estimates by a whopping $0.19. The company also raised its full-year guidance to $16.9 billion in revenue. Market consensus was only $16.6 billion. Full-year EPS also received a raise to $2.83, with market consensus at $2.68.


That’s a pretty strong beat, and yet the stock is flat from the day of the earnings release. This has everything to do with broader economic concerns and nothing to do with the company or stock itself. Here at BMR, we love fundamentally sound companies whose stocks are undervalued, and Salesforce epitomizes that better than anyone. In fact, we think Salesforce is one of the greatest companies in America.  Ten years from now this company’s stock will be many multiples higher.


BMR Take: Bank of America recently released its top 10 stocks for 4Q19, and Salesforce made the list. The recent $16 billion acquisition of Tableau provides the company the most powerful analytics tool on the market, and makes Salesforce that much stronger. Tableau hasn’t been integrated into the company yet, and will become a major revenue driver when Salesforce begins to fully-monetize it. Too many strong tailwinds to ignore this industry leader and pioneer.





Workday (WDAY: $161, up 13%)


Workday is another stock that was up handsomely all year, even cracking the $220 mark in July, but has since fallen from grace and is currently flat YTD. The selloff happened after several analysts took slightly bearish positions (we stress the word ‘slightly’), noting a slowdown in human capital management sector growth, and several Workday products that one analyst felt might be difficult to monetize.


Yet those same analysts – RBC, and Macquarie – maintain high Target Prices. RBC has a $212 Target Price, and Macquarie pegs Workday at $196 with an ‘Outperform’ rating. So what’s the problem here? Guggenheim recently threw their hat into the ring, calling the selloff an ‘overreaction,’ and maintaining their ‘Buy’ rating with a $235 Target Price, above our own $224 target (which is in-line with Goldman Sachs’ $223 target).


The simple fact is, the market is jittery at the moment, and any bad news – even a tepid analysis from a pair of analysts – is enough to send bulls running for the hills. But Workday is still a fundamentally sound company and a leader in the human capital management space. Both the sector and the stock have been growing rapidly, so a slight pullback for each was inevitable. All that matters is that more growth is around the corner.


BMR Take: If the lowest Target Price mentioned above is the one that Workday hits, that implies a 23% gain from where the stock currently sits. None of the analysts are predicting a pullback, the only question is how much growth is left on the table? We are confident in this company and industry, and feel the blip is only temporary. Workday’s selloff is a buying opportunity.





Square (SQ: $63, up 4%)


Square is down 25% from its 52-week high, yet still up 9% YTD. Concerns over a slowing economy negatively impacted Square, which makes money off of in-store consumer transactions. That said, fears of an economic slowdown are overblow, and with the Fed expected to juice interest rates with yet another quarter-point reduction next week, we’re looking for sentiment to improve over 4Q19, which would lead to a sharp turnaround for the company.


Square had a strong 2Q19, although the stock suffered after management issued conservative 3Q19 guidance. Revenue grew 46% YoY to $560 million, and EPS of $0.21 beat consensus estimates by a nickel. Yet management predicted $595 million in revenue for 3Q19, below the $600 million the market had been looking for. The main concern for Square is revenue growth deceleration, and the lower guidance fed into that story. Reduced revenue is already baked into the cake, so anything approaching $600 million will likely pop the stock back upward.


BMR Take: Square recently sold Caviar to delivery site DoorDash for $410 million, and lowered its transaction fee rate for U.S. purchases from 2.75% + 10 cents to 2.6%. The goal here is to attract more customers and grease up the revenue pipeline. Again, the main bearish concern with this stock is revenue growth deceleration, so if management can mitigate that, the stock should see a fast turnaround.





Twilio (TWLO: $107, flat)


Like the rest of this week’s stocks (with the exception of Dollar Tree), Twilio has had an up-and-down year, the stock is still up a healthy 18% YTD. The stock has shed 25% of its value since July, but we’re looking to get back as close to the $140 range as possible by year-end.


Twilio had a strong 2Q19, with $275 million in revenue for an 86% YoY gain. EPS of $0.03 beat market estimates by a penny. Management also raised its 3Q19 revenue guidance to $288 million, up from $286 million. Yet the company posted results at the wrong time (which can happen). The stock slid in August as the broader market suffered from extreme anxiety, and the stock simply hasn’t recovered since.


The good news is that with a major selloff due to fears over macro-conditions as opposed to company fundamentals, we have a value investment on our hands. Twilio just posted extraordinary revenue growth and raised its forward-looking guidance. The company is on extremely sound footing. Once the market gets over its jitters, the stock will be soaring back to new heights.


BMR Take: We’re not the only ones bullish on Twilio. Morgan Stanley recently rated the stock ‘Overweight’ with a $135 Target Price, and RBC rated it ‘Outperform’ with the same target. That’s below our $156 Target Price. Twilio is the leading communications-as-a-service provider in the world, and with more and more companies utilizing the cloud to reach their customer bases, this stock has nowhere to go but up.





A Word From Gary Jefferson

Jefferson Financial Group
First Vice-President, Investments
UBS Financial Services, Inc.


Earnings season continues in full swing this week with many big names already reporting. Highlights include: McDonald's, Procter & Gamble, UPS, Caterpillar, Boeing, Microsoft, Ford, 3M, Twitter and Amazon, just to name a few. At this point 40% of S&P 500 companies have reported actual results to date for the third quarter. Despite media attempts to convince us we are experiencing the beginnings of a recession, 80% of companies have reported earnings above forecasts, while 64% have reported sales above estimates.


Averaging the many projections we've seen, we believe GDP growth comes in at an annualized rate of around 1.8% for the third quarter, far from the recession zone. Yes, that's a little slower than last quarter's 2% rate, but while the U.S. economy may not be booming, it is still growing. The actual data back it up far better than the rhetorical hype cramming our airwaves. Single0family home starts are up 4.3% YTD and permits are up 2.8%. As much as we lean on "earnings, earnings and more earnings" as key to the stock market, housing is a leading indicator which gives us a good signal for which way the real economy is heading.


Corporate earnings get a lot of attention but remember that these reports are a look in the rearview mirror and Wall Street's reaction depends heavily on "guidance" as a gauge of what the future will bring. Home construction is a real brick-and-mortar look at long-term confidence.  And confidence among investors, as a general rule, typically builds when their risk of suffering a quick and sharp loss declines considerably.  Since the U.S. and China took a constructive step forward in resolving their trade dispute, this risk has dropped.


Consumer sentiment remains strong and clearly supports a bullish outlook.  Any one worried about an oncoming recession should look at consumer sentiment as the pressure you put on the gas pedal. As we head into holiday shopping season it appears that the "pedal is to the metal."


Looking out longer term, the election will almost assuredly play a major role on the direction for stocks for much of 2020.We remember the last one when many of the smartest people in the world predicted doom and one, in fact, was a Nobel winner who emphatically stated that there was a 100% certainty that the stock market would crash if Donald Trump was elected president. Because this kind of rhetoric will likely rule the airwaves, investors may turn cautious or get more guarded with their capital by the summer at the latest.


Thus, even if the fundamental backdrop doesn't deteriorate, equities may consolidate in the several months prior to America heading to the polls next November, so it is important to keep in mind that these same fundamentals should act as solid support for the continuance of this bull market. In other words, it's never too early to remind investors to try and keep emotions in check while staying focused on the fundamentals. Election rhetoric has never been an indicator that a recession is on its way.





Earnings Preview: Spotify (SPOT: $121, up 5%)


Earnings Date: Monday, 8:00 AM ET


Expectations: 3Q19
Revenue: $1.7 billion
Net Loss: $43 million
EPS: -($0.28)


Year Ago Quarter Results
Revenue: $1.3 billion
Net Profit: $43 million
EPS: $0.23


Implied Revenue Growth: 30%
Implied EPS Decline: swing from profit to loss


Target: $198
Sell Price: $160 (temporarily suspended)
Date Added: April 12, 2018
BMR Performance: -19%


Key Things To Watch For in the Quarter


Last year's profit was a surprise to everyone, including management, which is still concentrating on building Spotify's global audience before real efficiencies of scale kick in. In the grand scheme of things, it could take at least another year for that to happen, which means a swing back to a loss is no cause for concern. Even now, there's an outside chance that a significant revenue surprise will translate into the company booking up to $3 million in profit.


However, we're just here for the sales trend. On that front, management has told us to expect around 30% growth, which is healthy enough for a stock with this level of world-changing ambition. They want to become the world's new outlet for music, talk and even local news, effectively replacing terrestrial radio and all physical audio entertainment systems with a single bound. Of course to get there they need to go around entrenched competitors like Apple, Alphabet and Amazon, but so far we don't have any complaints.


Audience size is critical here. We need to see that Spotify is still growing its user base. Three months ago they thought they'd show about 4% sequential growth, which means adding 10 million monthly listeners. Whether those accounts are paid subscribers or subsidized by advertising doesn't really matter. Spotify will make money either way. If anything, we suspect the free channel will be the real gold mine here, so pay especially close attention to comments on that side of the business. Remember, radio survived for generations on a free listener model because sponsors carried the freight, and in modern times free Spotify can compete with any price point Amazon and other rivals care to set.





Earnings Preview: Alphabet (GOOG: $1,265, up 2%)


Earnings Date: Monday, 5:00 PM ET


Expectations: 3Q19
Revenue: $40.3 billion
Net Profit: $8.7 billion
EPS: $12.38


Year Ago Quarter Results
Revenue: $33.7 billion
Net Profit: $9.2 billion
EPS: $13.06


Implied Revenue Growth: 20%
Implied EPS Decline: 5%


Target: $1,450
Sell Price: We would not sell Alphabet.
Date Added: February 2, 2016
BMR Performance: 65%


Key Things To Watch For in the Quarter


Tomorrow afternoon's main event probably won't give us too many thrills, but when you're the third-largest U.S. company the goal is really to avoid rocking the boat. We know Alphabet is at a challenging point in its evolution from simple online Search Engine and Online Advertising hub to something more sophisticated. Artificial Intelligence will play a huge role in that, but for now it's simply a huge drag on the bottom line.


In the meantime, Alphabet is all about revenue. It's hard to argue when a company this big finds a way to squeeze an incremental $7 billion in sales out of its existing business. That's exactly what management has signaled they're doing. With that in mind, all it takes is for Alphabet to start growing the bottom line again is for Artificial Intelligence projects to start paying off. Turn that cost center into a sales center and the money flows fast.


Watch the details on the company's "moon shots" especially carefully. Management could announce a breakthrough on Automotive applications, Healthcare or even the Smart Home at any time. When that happens, investors will definitely sit up and take notice.






Earnings Preview: Vornado (VNO: $64, up 3%)


Earnings Date: Monday, 5:00 PM ET


Expectations: 3Q19
Revenue: $473 million
Net Profit: $143 million
EPS: $0.74
Funds From Operations: $1.43


Year Ago Quarter Results
Revenue: $542 million
Net Profit: $66 million
EPS: $0.35
Funds From Operations: $0.95


Implied Revenue Decline: 13%
Implied EPS Growth: 110%
Implied FFO Growth: 50%


Target: $80
Sell Price: $50
Date Added: March 5, 2018
BMR Performance: 3%


Key Things To Watch For in the Quarter

Vornado is a little smaller on the top line after selling a few marquee properties, but the slimmed-down operation is a lot more efficient than it was a year ago. In our view, profit here doubled even though overall rent coming in shrank 13%. Whether that's the start of a new trend remains to be seen, but in the world of Real Estate so much depends on the accountants' whims that we aren't really holding our breath either way.


Funds From Operations are always the metric we study because there's a direct relationship between how much money the property portfolio is throwing off and the dividends shareholders will receive. For Vornado, any FFO better than $0.66 will support the current payout and raise the question of how much management is thinking about raising it next year. Last year we got a 4% quarterly increase. While that was good, we think 2020 will be even better.






Earnings Preview: Akamai (AKAM: $89, down 3%)


Earnings Date: Monday, 5:00 PM ET


Expectations: 3Q19
Revenue: $700 million
Net Profit: $165 million
EPS: $1.00


Year Ago Quarter Results
Revenue: $670 million
Net Profit: $158 million
EPS: $0.94


Implied Revenue Growth: 4%
Implied EPS Growth: 6%


Target: $100
Sell Price: $77
Date Added: June 8, 2018
BMR Performance: 14%


Key Things To Watch For in the Quarter

Even though these numbers will probably get lost in the overall Alphabet buzz, little Akamai is still a stock to reckon with as management keeps pivoting from legacy Online Content services to more profitable Security and Traffic Management functions. That's how you stay relevant after decades in Silicon Valley, and while the business as a whole isn't growing fast, we like the way the mix is changing.






Earnings Preview: Welltower (WELL: $88, down 4%)


Earnings Date: Monday, 5:00 PM ET


Expectations: 3Q19
Revenue: $1.3 billion
Net Profit: $188 million
EPS: $0.47
Funds From Operations: $1.04


Year Ago Quarter Results
Revenue: $1.2 billion
Net Profit: $64 million
EPS: $0.17
Funds From Operations: $1.04


Implied Revenue Growth: 8%
Implied EPS Growth: 175%
Implied FFO Growth: unchanged


Target: $89
Sell Price: $72
Date Added: March 22, 2018
BMR Performance: 50%


Key Things To Watch For in the Quarter

After Ventas on Friday, the Healthcare REITs are under quite a bit of undeserved pressure. Welltower's numbers give the group a chance to turn the trend around. After all, experienced investors aren't going to be upset by relatively flat revenue leaving Funds From Operations roughly unchanged . . . all we want is for the numbers to hold up and support the $0.87 dividend.


However, casual investors who have been crowding into every stock with a yield may be impressed if Welltower gives us the earnings growth we expect. Going from $0.17 to $0.47 is only a thrill when that's the only number you look at. BMR subscribers know the accountants can work all kinds of magic to engineer whatever year-over-year comparisons they need, and then next quarter the math will go just as suddenly in the other direction.


Still, triple-digit growth is an achievement that in this nervous market might earn some applause. For us, the only real objective here is for Welltower to hit its numbers. If management decides to raise the dividend for the first time since 2017, it would be a welcome bonus.





Earnings Preview: Shopify (SHOP: $317, up 1%)


Earnings Date: Tuesday, 8:00 AM ET


Expectations: 3Q19
Revenue: $383 million
Net Profit: $13 million
EPS: $0.10


Year Ago Quarter Results
Revenue: $270 million
Net Profit: $4 million
EPS: $0.04


Implied Revenue Growth: 40%
Implied EPS Growth: 150%


Target: $450
Sell Price: $315
Date Added: March 29, 2017
BMR Performance: 341%


Key Things To Watch For in the Quarter

Shopify remains all about expectations. Look at those targets. While the company is still barely over the edge of breaking even, earnings are now expanding fast as 40% sales growth feeds more money through the business every day. Management has barely started monetizing the Electronic Commerce platform much less capturing the truly disruptive (and ultimately lucrative) Direct Retail relationships that let consumer manufacturers bypass stores entirely and ship straight to consumers. We're truly in the early stages.


Of course the stock has quadrupled in the 2-1/2 years we've been covering it, so a lot of optimism is already built in here. Shopify can't coast. It needs to hit its marks or suffer the consequences of sudden disappointment. Even our targets are a little above the range management told us to expect three months ago, so we concede there's room for a miss. As long as the core growth trend remains intact, there's no need for concern . . . any dip we see on Tuesday is more likely to be a buying opportunity than a real sell signal.





The High Yield Investor


By John Freund
VP of High Yield
The Bull Market Report 


This week we’re going to look at a pair of stocks we removed from the portfolio after the yield curve inverted earlier this year, and which we are now prepared to reinsert back into the portfolio. We’re going to explain our reasoning both for removing them and for bringing them back.


But before we do that, let’s offer a brief explanation of the yield curve and what it means for it to ‘invert.’ The yield curve is the difference (or ‘spread’) between short-term notes and long-term bonds. There is no official definition of what constitutes long and short-term, so when researching ‘the yield curve’ you might find different duration noes and bonds being cited. However, the 2-year vs. 10-year Treasury note is a standard comparison that many investors look for when assessing the broader bond market.


On August 14 of this year, the rates on 2-year and 10-year notes inverted. The interest rate on the 2-year rose above the interest rate on the 10-year. Think about that for a minute: It means that investors actually received a higher rate of return for committing their money to two years in Treasury notes than they did for parking their money in Treasury bonds for a decade.


As the following chart shows, the inversion was very brief, but it sent shockwaves throughout the investment landscape, because a yield curve inversion many times signals that investors are predicting the economy will be weaker in the future than it is today (a weaker economy implies lower interest rates, so when the 10-year dips below the 2-year, it implies that investors feel the economy will be weaker in the future). What’s more, the last time the yield curve inverted was 2007, about a year before The Great Recession. Inverted yield curves have a habit of predicting recessions (though this isn’t always the case).


We cut our curve-sensitive recommendations once 10-year yields dropped below their 2-year counterparts, reflected here as a reading below zero:



So August 14 was a big day for the market (even though other yield curves between longer and shorter-term notes and bonds had been inverted for months prior – such is the power of the 2-year vs. 10-year). It was also a big day for The Bull Market Report, because we promptly dropped a trio of stocks from our portfolio: Annaly Capital (NLY: $8.79, flat, Yield = 11.3%), New Residential (NRZ: $15.68, up 1%, Yield = 12.7%), and AGNC Investment Corp (AGNC, $16.54).


Today we are reinstituting two of those: Annaly and New Residential. Let’s take these two stocks one at a time, and explain why we dropped them and now why we’re bringing them back.


Annaly is by far the largest Mortgage REIT in the world. With a market cap of $13 billion, the company has over $100 billion in AUM. Most of that is in agency mortgage-backed securities (MBS), which are loans backed by the federal government through Fannie Mae, Freddie Mac and Ginnie Mae. Annaly makes money by borrowing at short-term interest rates in order to fund the purchase of longer-term MBS. So when the yield curve inverts, Annaly has issues. Suddenly short-term interest rates are higher than longer-term rates, which throws Annaly’s entire business model out of whack.


So that’s why we ditched Annaly in mid-August. With the yield curve inversion, we didn’t want to risk owning Annaly when who knows how long the yield curve would stay inverted for? Now that the yield curve has started to revert back to normal (albeit slightly), we’ve decided to reinsert Annaly into the portfolio.

Granted, the stock is essentially flat since the inversion, so all told we could have just held onto the stock, but we played it safe and didn’t lose much (only a couple percent on the dividend payout). The good news going forward is that the stock is already at historic lows – just a bit above its all-time low. This is the largest Mortgage REIT in the world, and one that currently delivers an 11.3% annual yield. So we’re very comfortable investing in Annaly going forward, especially with the Fed lowering interest rates and the yield curve reverting back to normal.


What’s more, Annaly recently cut their dividend by 17%. Management made that tough decision in order to conservatively protect against any potential losses from a downswing in the economy. So Annaly is well-positioned going forward, especially if the economy improves from here. And with the Fed juicing the broader economy by lowering interest rates, that looks to be a sincere possibility.


Annaly got a slight jolt a week ago when Bill Gross – ‘the bond king’ and founder of Pimco – announced he is investing in the stock. “I’m in there for the yield,” Gross said, as he predicted the spread on the 2-year and 10-year will continue to widen. Who are we to disagree with the bond king?


Note, the spread between the 2- and 10-year note is about 19 basis points. We’ve watched it widen from close to zero in August. This is what you should watch like a hawk. CNBC has it on all day long, and The Nightly Business Report on PBS has it on every night. WATCH IT LIKE A HAWK.  If it continues to widen, great news.  If it tightens, be prepared to sell Annaly again.



The other stock we are adding back into the portfolio is New Residential. This is a slightly different story from Annaly. The company is the largest non-bank holder of mortgage servicing rights (MSRs) in the world. New Residential essentially invented a new industry, when post-Great Recession the company began scooping up MSRs from banks who were offloading them for pennies on the dollar, due to regulatory concerns.


MSRs provide the right to service an ongoing mortgage. So the longer the lifetime of a mortgage, the more money New Residential makes as it has more years to service that mortgage. Here’s the thing though: When the yield curve inverts, it sends the interest rates down on mortgages. When that happens, people tend to refinance, as they can get a better interest rate on their mortgage. If refinancings go up, then New Residential is in trouble, because the lifetime of their loans goes down, which means the value of those loans decreases.


So that was why we left New Residential in mid-August. Our theory proved correct… for a couple of weeks. But then in September the stock rebounded, and has since increased 13% since the yield curve inversion. The company made some aggressive moves in that time, authorizing the repurchase of $200 million worth of stock, and acquiring Ditech Financial for $1.2 billion, which brings in both agency and non-agency MSRs.


Management did a great job of buoying the stock during an otherwise rough patch, and now that the yield curve has widened New Residential is on a stronger footing. The 3Q19 numbers were just released this week, and they were a mixed bag, with book value creeping up 1% from the prior quarter to $16.17, yet EPS of $0.50 falling 1% from the prior quarter, and missing analyst expectations by 1%. These aren’t huge misses or gains either way, so we don’t see the earnings greatly impacting the stock in the near-term. Plus, we’re in this stock for its 12.7% yield, and going forward that yield looks safe thanks to improving macro-conditions.



We always thought both Annaly and New Residential were great companies, and fundamentally sound. We just wanted to play it safe with the yield curve inversion. While Annaly remained flat, we did miss out on some gains with New Residential. That said, our strategy in The High Yield Investor is to remain conservative (these are defensive, income-producing stocks after all), so we played this one conservatively.


We should also mention that we’re not completely out of the woods yet in regard to the yield curve. The curve is widening, but is still historically flat. While we agree with Bill Gross that the curve will likely continue to widen, no one can say for certain. That’s why we recommend tip-toeing back into these stocks, with a light-touch investment at first, just to see which direction the winds are blowing before making a full commitment. It’s the same reason we aren’t getting back into AGNC, by the way. The company is essentially a smaller version of Annaly. We’re making our way back into these stocks slowly. But we think surely. If the yield curve continues to widen, we’ll take another look at AGNC down the line as well.


Good Investing,
Todd Shaver, Founder and CEO
The Bull Market Report
Since 1998