The Week Ahead
We see the week ahead as “The calm before the storm.” We expect a quiet and peaceful period as many are still out on vacation, earnings season is said and done, and the schedule of major market events is light. These are the dog days of the summer. However, very soon, back to school go the kids, back to peak capacity it will be for Wall Street trading desks, back to Presidential debates on TV, and back to the usual frenzies the financial media outlets love to stir up. With so much happening from Presidential politics, to the Fed’s monetary policy experiment, to record highs for the major indices, there is just no way the markets will remain this quiet for much longer. We strongly believe that there remains money to be made in equities. This week we highlight Apple, Home Depot, Splunk, Gilead and Annaly.
Here is How The Major Indices Performed Last Week
Here is How Last Week Progressed
Monday (8/16) - S&P 500 +0.3%
The value of negative yielding bonds in the world rose to $13.4 trillion from $13.1 trillion a week ago. Italy, Spain, and now Portugal are all running above 10% of total assets invested in their own sovereign debt, a very concerning signal for European banks. Short interest in the S&P tumbled to three year lows. Billionaire David Tepper of Appaloosa Management commented that confused central bankers are distorting bond yields which has been affecting equities in a negative way.
Tuesday (8/17) - S&P 500 -0.5%
The US dollar fell to a 3-month low as rate hike odds pulled back. Core CPI remained above the Fed’s mandated 2% for the 9th consecutive month. Housing starts jumped on a spike in rental units, as permits declined. The US industrial production index slumped to the longest non-recessionary contraction in history; notably the softness began at the time the Fed ended QE3. Intermodal freight carloads took their first dip in 25 quarters. The Port of Long Beach reported an 8% drop in container volumes from last year.
Wednesday (8/18) - S&P 500 +0.2%
After several quarters of deteriorating results, US retail giant Walmart (WMT: $73, $230 billion market cap) beat EPS estimates, but more importantly guided to a higher profit outlook for the year, as comparable sales in the US remained positive for the 8th consecutive quarter and are not expected to taper off as some feared. Separately, while the relentless decline in Caterpillar retail sales has been occurring for 44 consecutive months, the latest July data was downright disappointing with North American machine sales down 20% after falling 12% in June. Not good.
Thursday (8/19) - S&P 500 +0.2%
Billionaire Paul Singer of Elliott Management declared that we are in the biggest bond bubble in world history due to the unprecedented actions of central banks. Money flows into emerging markets are at a record pace. Money flows out of Europe for the 28th consecutive week also set a record. Corporate defaults so far this year are up 57% with the only higher period being 2009. Companies in the Energy and Natural resources industries account for more than half of the defaults.
Friday (8/20) - S&P 500 -0.2%
New British Prime Minister Theresa May said that “Article 50”, which is the legal execution of Brexit, may be triggered before April in order to occur prior to French and German elections. It is expected that there will be two years of negotiations after the trigger, which will be when we learn of all the specific details of what UK’s withdrawal from the European Union will look like and mean. Oil prices rose not on fundamentals, but rather on what the Saudi officials are saying about production forecasts. Cathay Pacific (the airline) reported weak earnings due to collapsing corporate travel in China. The Vancouver housing market in Canada fell 20% from the last month, finally confirming concerns there are serious problems ahead for Canada’s real estate market.
The Bull Market Report Companies and Commentary
Home Depot (HD: $136, -1%) Home Depot recently reported 2Q16 EPS of $1.97, which was on par with the Street’s expectations, driven by solid sales growth and operating expense leverage. Sales increased 6.6% from last year with comparable same store sales up 4.7% (US comps were up 5.4%.) Gross margin was flat from last year at 34%. There was a 22 basis point gross margin headwind (a negative) related to the acquisition of Interline, a home repair and maintenance product line. However, gross margins did benefit from more favorable supply chain and rebate costs. Total expenses as a percent of sales showed a 40 basis point improvement, which is a good thing when you can grow revenue but holding fixed costs steady.
2016 EPS guidance was adjusted upward to $6.33 from $6.27 with comparable same store guidance of an increase of 5%. Overall, performance at Home Depot remains strong. In fact, June and July trends were stronger than expected and management described August as “very pleasing”, which points to upside to third quarter results. Looking ahead, the key questions are how the sector can perform into year end, relative to very strong year-ago results and how the broader housing cycle will perform from here. We don’t see any signs of weakness on either front.
BMR Take: We remain positive on the fundamental trends driving business performance. We see further upside potential in the stock.
Splunk (SPLK: $65, +1%). Splunk is scheduled to report second quarter earnings after the markets close on Thursday. The whisper on Wall Street is that channel checks on sales force productivity indicate that the consensus could prove conservative. Specifically, the Street’s $110 million license revenue estimate implies a mid-single digit decline in productivity, whereas channel checks indicate that performance of flat to slightly positive growth could be in order. This implies potential upside on license revenue, which translates into modest upside to operating income and EPS relative to Street estimates.
So what are the channel checks? An analyst at a Wall Street research firm conducted a round of conversations with resellers, technology partners, industry consultants, and customers, where the dialogue pointed to Splunk witnessing healthy demand. There was feedback of very healthy uptake of the company’s newer premium applications (ITSI and UBA), which should help support the top line over time even as the company continues to drive down cost of ownership for customers. Moreover, partners called out a number of larger deals, with a few transactions above the seven figure mark.
BMR Take: A good round of channel checks is the basic blocking and tackling of quality research. Admittedly, the outcome is not always as expected. But we do like what Wall Street is saying about the upcoming quarter verifying our existing admiration for the company.
Gilead Sciences (GILD: $81, +2%). Year-to-date Gilead is down 20% versus the S&P 500, up 6%. Wall Street is not happy and is now calling for action. Specifically, there is growing discussion about pushing Gilead to split into two pieces: the HIV and HCV (hepatitis C) franchises. (Gilead’s HCV drugs, Sovaldi and Harvoni, proved to be breakthrough therapies. They managed to report cure rates up to 99%.) Consensus says the plan to split the business is a good idea and moving forward would be applauded. The hyper focus on HCV is thought to be distracting. The HIV business is thought to be materially undervalued and robust. We are very positive on a potential breakup if it were to occur, as tearing HIV and HCV apart will require little – just replication of sales forces, commercial infrastructure, administrative efforts, and virology R&D, so the lost synergies are manageable. Some say that the two business have synergies from being run together so if you split it up, it will introduce more costs.
If it’s not possible to split up the company, then an alternative could be to work on better highlighting that the HIV business is growing well. Perhaps some of the non-core assets could be sold. On a standalone basis the HCV business is thought to be worth around $65 per share, but that's without a few products with bright futures (If you want to do more reading on the topic, google “1/d unboosted integrase and TAF/Emtriva.”) These products should be worth about $25 a share, so this would get the shares to above current value, ($90), leaving all the other businesses as upside to the current valuation in a split or asset sale.
Piper Jaffray has placed a price target of $108, up from the previous target price of $80 to Gilead. They have a Buy rating on the stock with an expectation of an upside trend due to its robust and competitive drug pipeline. They feel that a 10 PE is warranted, up from 7, and if this happens, you are looking at a 40% rise from the current price.
BMR Take: We see a possible catalyst emerging for Gilead with this growing discussion around business reorganization as well as the new drugs noted above. While shares are underperforming year-to-date, we would hold on and add to positions.
First Solar (FSLR: $38, down 2%) had its price target lowered by Goldman Sachs from $67 to $58 on Tuesday. They have a Buy rating on the stock. Per our News Flash on August 10th, we are buyers of this stock. It may take many moons for it to start moving again, but we have faith in the industry and this company in particular. We are glad to see that Goldman Sachs does as well.
Annaly Capital Management (NLY: $10.94, down 1%) was down a little this week. But in our opinion it is just noise. The stock is paying an 11% dividend with a market cap of $11 billion. We talk to people here in Aspen and around the country all the time about Annaly. Many investors have “gotten it.” But many can’t believe what the company is doing and has done. Annaly has been doing this since 1997, paying a dividend that has ranged from 10% to over 20%. They use leverage to make this happen and this is why some people shy away from the stock. They used to use a lot more, but are much more conservative in their use of leverage than in the late 90s and 00s.
Here’s how they do it: They take their capital and buy Fannie Mae, Ginnie Mae and Freddie Mac securities that are backed by the full faith and credit of the United States. These securities are paying between 2 and 3%. Then they go out and borrow up to five times their capital and buy additional Fannie securities, and collateralize their borrowings with these same securities. This allows them to borrow at rock-bottom rates of well less than a half of one percent. The spread between borrowing and the yield they get for the Fannies, multiplied by a factor of five allows them to produce a net profit of 12-13%, and after expenses they can pay an 11% dividend.
Is there risk? Of course. Any stock paying more than 3-4% involves risk. But they have been doing this for 20 years through bull and bear stock markets and bull and bear debt markets. They are the masters of controlling risk. And every time there is a hint or discussion of higher rates the stock goes down a bit because investors think their cost to borrow would go up. But rates have been going down for 29 years! This is not a misprint. But the risk is misplaced with Annaly because if rates were to go up, they would go up slowly and in actuality, higher rates are good for Annaly. Why? Because the Fannies Maes they buy would be paying a higher rate.
And think about this. If investors buy the stock, two things happen. The stock goes up and the dividend rate goes down. If the stock goes to $12 in a year, that’s a 9% return and if you add the 11% dividend that gives you a 20% return, plus you are locked in with the 11% dividend, even though the yield might go down to 10%. Get it?
BMR Take: Reread the four paragraphs above! Do you think we like Annaly? Or not?
Upcoming Economic News
We are very focused on the US GDP outlook. The Fed’s expectations for growth currently shows 2.2% in 2016, 2.2% in 2017, 2.0% in 2018, and 2.1% in the longer run after 2018. However, the Fed has moderately been lowering expectations for some time. The second quarter is seasonally slow so the 1% growth result likely to be reported this week is not particularly concerning at first glance.
However, what is concerning is that the Fed’s GDP outlook calls for essentially unchanged conditions for the foreseeable future. Over long periods of time financial markets are anything but smooth and predictable. With some pockets of the economy under stress, as we have been highlighting in The Bull Market Report, we have a watchful eye on the Fed's GDP outlook. We are concerned a more sluggish GDP scenario could unfold than what they are predicting. It is very unclear how the Fed could address such a situation considering interest rates are already set near the zero level. We are worried that an out-of-position Fed could compound the negative effect to markets if we do see a GDP slowdown.
The Apple Corner
Apple (AAPL: $109, up 1% for the week) is worth $10 billion shy of $600 billion - still the largest market cap in the world. Lately the stock has been doing well, up from $97 on July 26th, a short three weeks ago. As we like to say, the stock has been trickling up. And this on no significant news. Ah – the news. In Apple’s case, no news is good news. Why? Because we KNOW that by just doing what they do they will generate news IN DUE TIME. The iPhone 7 is coming in September. We KNOW this. Will be write about it incessantly? NO. Because everyone else will write about it. But we know when it comes it will be BIG. Right before Christmas so that people can open their wallets to buy the best and greatest technology on the planet. They will sell MILLIONS of iPhones. Should we speculate on how many? No need to. But every new buyer will open up an iTunes account and buy music; and every new buyer will start buying apps in the App Store and Apple’s cash hoard will grow. (It is currently at $232 billion and growing by about $1 billion every eight or nine days.)
BMR Take: Are we buyers? Do we like the stock. You bet. We still believe the all-time high of $134 is sitting there waiting to be reached. When will this happen? Could be this year; could be next year. We would even be happy in early 2018. If the stock hits $140 in 2018 giving you a 28% return (plus the 2% dividend), would you be happy with that? Well, WE WOULD!
The Apple Corner – Take Two
As has been widely reported, Apple is working on a car through Project Titan. We know that working on a product doesn't always result in a product launch, but nonetheless, reports suggest that the company has over 1,000 people working on Project Titan. Apple has around 18,000 employees in research and development out of 115,000 employees in total. If you assume most of the people working on Project Titan are engineers, it would mean that about 5-6% of the company's research and development group is working on this. Apple put Bob Mansfield in charge of the project in July after the former head left in January. Mansfield has been an executive at the company since 1999 and previously worked on iPod and Mac hardware. Initial reports suggest that the car has a "target ship date" of 2019. We think it is more likely in 2021.
Apple could release some of its learnings before 2021 as it continues to develop its own car. For example, autonomous driving software could come out earlier. In terms of the market, BMW might be the best comp for what Apple could do with the car in a wildly successful long-term scenario. BMW sold 1.9 million vehicles worldwide in 2015. At a $70,000 average selling price, that would represent a $130 billion revenue opportunity for Apple. The bottom line is that the car, while it could still be scrapped, has the potential to be a true needle mover.
BMR Take: We continue to see long term upside for Apple from a wide range of areas, like Titan. With net cash per share of $43 and a 2% dividend yield, the value we see in the shares at current levels is compelling. By the way, in the second quarter Warren Buffett’s firm upped its Apple stake by more than 55%. Incredibly, Berkshire now owns $1.65 billion of Apple stock.
Some Thoughts from Gary Jefferson
Jefferson Financial Group
First Vice-President, Investments
UBS Financial Services, Inc.
Over the past few days we have reviewed several interesting market opinions. These two caught our attention.
Smart vs. Dumb Money. The assumption is that the smart money is "commercial" – i.e., these are real investors who hedge their company's positions, like airlines buying oil futures to hedge against rising oil prices. The dumb money is the large speculators. They include the trend-following hedge funds and traders that buy more as the trend goes up and then sell more as it goes down. The premise is that there is a good way to tell when major markets are getting ready to reverse - just look at the traders' position in the futures markets. When there are large and growing divergences between these two groups, a major reversal is coming. And, the smart money is called that because they are right a great deal more often than the dumb money. Today, the smart money in futures is extremely short in T-bonds, oil, commodities and stocks – (all at the same time.) The dumb money is near record long in most of these same areas. This is a huge divergence and is forecasting a major market reversal. (Dent Research 8/2/16)
[This is of course in the For-What-Its-Worth department. Otherwise known as food for thought.]
High Dividend, Low-Volatility Stock Bubble. It's general knowledge that high-dividend, low volatility shares have been one of the best winners of the past few years. The premise is that investors have withdrawn funds from safe bank accounts because they wanted to generate income of 3%-4% while being in the most stable securities that could generate such yields. This popular (and dangerous) method of investing has created valuations almost double the fair value for these stocks which are generally found in Consumer staples, REITS, Telecoms and Utilities. (We used to call these "widows and orphan" stocks). One has to also consider the fact that the total assets in one of the most popular low-volatility ETF's called the iShares Edge MSCI Minimum Volatility USA Fund (USMV; $46) have tripled in the past year. Like all past bubbles, no one can imagine that these kinds of securities can lose half or more of their value. When it comes to bubbles, historically it is the most wildly trendy and popular trades that have always proven to be disappointing.
The dumb money theory is interesting and we'll store that away in our tool box of market forecasting. There are literally dozens of valid methods upon which to base market valuations and forecasts, but we've never found one that could stand on its own. That's the reason for a well-stocked tool box. The time to get concerned is when several of these tools start signaling coming economic strains or market red flags. The most valuable forecasting tool for us has always been "earnings." Today, we believe the argument for remaining bullish still outweighs the bearish one, although that will be dependent on earnings forecasts continuing to be met.
We tend to agree with the overcrowding in the high dividend, low volatility area, although we are not so sure about it being in bubble territory. Investors are now faced with a scarcity of attractive asset choices, and they need to be made aware that these kinds of stocks can't be expected to hold valuations that become too high. In other words, investors may need to be a lot more realistic about the returns that can be achieved within traditional risk tolerance parameters regardless of how "safe" certain stocks seem to be.
High Yield Corner
The market’s appetite for high yield remains strong. While investors aren’t exactly insatiable when it comes to income, they aren’t shying away despite the now well-known fundamental and macroeconomic headwinds that threaten many high yield investments.
Let’s start with junk bonds. The iShares iBoxx High Yield Corporate Bond ETF (HYG: $87) ended the week up slightly and with little volatility. The beta for this ETF now stands at 0.47 - much lower than it has been in the past. As a measure of volatility relative to the market as a whole, beta tells us that the market sees half the risk in junk bonds as in the broader market.
How is this possible when Moody’s and others are warning that defaults are spiking? Simply put, the market feels they have already discounted the potential risk of defaults in junk bonds, and that the lows of February were an overreaction to a now well-known risk.
A similar attitude has evolved in the BDC world, as evidenced by the over 1% rise last week in the UBS Etracs BDC ETF (BDCS: $22). With an 8% year-to-date rise and a current dividend yield over 8%, this ETF’s performance reflects the market’s continued belief that BDCs can manage non-accruals and defaults in their portfolios.
As companies that manage loans to middle market companies, and which usually have no rating at all, BDCs are considered higher risk than junk bonds in that they carry a portfolio of loans that are likelier to default. BDC managers are there to make sure that doesn’t happen. They do this by selectively accumulating a portfolio of loans that are less likely to default, and pricing interest rates high enough to compensate for non-accruals should they come.
Main Street Capital. Some BDCs are better at this than others. The Bull Market Report favorite, Main Street Capital (MAIN: $34) is a prime example. This fund’s portfolio remains robust and has weathered the past year without a rise in non-accruals. Even as default rates have more than doubled in the past year in the junk bond market, Main Street’s theoretically riskier loans have not provided rising defaults at all. Of the last four quarters, net investment income has beat consensus three times and met expectations once. In fact, the company’s ability to beat expectations has improved in the last year, which is partly why the company has been trading near or at its 52-week high for a while now.
And an announcement from last quarter demonstrates the company’s continued ability to drive investment income with savvy investments. A couple weeks ago, Main Street announced it received its third license from the Small Business Association, which will allow it to make new loans worth $125 million to small businesses. While the concept of small business loans sounds risky in theory, Main Street has proven their ability to make these investments without suffering non-payments.
In its last quarter, Main Street had half of 1% of its portfolio in non-accrual status, which is far less than the over 5% default rate in the junk bond market. Clearly, management is doing its job of choosing loans that will reward shareholders, making it a continued hold for us even as its price tests new highs.
Junk Bonds. The need to stay diligent and avoid defaults is stronger than ever, especially as junk bonds remain overpriced and yields remain low. The best way to gain exposure to junk bonds and avoid defaults is to choose a diversified and actively managed fund that has some junk bonds, but that hedges this with exposure to other kinds of loans, providing a high and reliable level of overall income.
Pimco Dynamic Income Fund (PDI: $29) For a long time, we have recommended this one for the very reason note above. Unfortunately, this week the Pimco fund massively underperformed the junk bond market, losing 1% of its value. However, it still remains up 3% in the last month and up over 4% year-to-date. The fund’s 9% yield excluding special dividends is a good reason to keep the fund, and this is compounded by the fact that its high yield exposure is less than half of the fund, with mortgage backed securities - which have been a strong performer for years now - comprising the bulk of the fund.
We remain long this fund and recommend readers do the same. A correction in the junk bond market might hurt this fund in the short term, so be aware - but that correction might not come. The best course of action, then, is to hold and enjoy the fund’s income and buy on dips if those come. From a risk/reward standpoint, this investment far exceeds the potential of holding an index fund for junk bonds, which offers a lower yield and greater exposure to rising defaults.
Finally, a quick word on REITs: the SPDR Dow Jones REIT ETF (RWR: $100) lost nearly 2% this week as many REITs suffered after the Federal Reserve hinted that an interest rate hike is to come. If this does happen - which is not certain, since we’ve known the Fed to get skittish about rate hikes before - high yield instruments will be affected across the board. But no sector has done so well in 2016 than REITs, making them particularly susceptible. This is why Bull Market Report picks in the REIT space had a little trouble last week: Kimco Realty (KIM: $30)*, Government Properties Trust (GOV: $23), and Omega Healthcare Investors (OHI: $36) all fell over 2% this week.
*Note that Kimco Realty announced a public offering of $500 million aggregate principal amount of notes due 2026 at a coupon of 2.8% per annum with an effective yield of 2.9%, maturing in 2026. The company intends to use the net proceeds of approximately $490 million from the offering to fund the previously announced redemption of $290 million aggregate principal amount of its outstanding 5.70% Senior Notes due May 1, 2017, with the remainder to be used for general corporate purposes, including to pre-fund 2017 debt maturities, including $135 million of mortgage debt outstanding with an interest rate of 6.3%.
BMR Take: In the long run this is awesome news for the company. In the short run the stock sold off, which is normal Wall Street behavior. For us at The Bull Market Report we look at this as a buying opportunity. Smart investors always look to the long term benefits of news like this.
More declines may come for these REITs after the large increases we have seen in the past. Yet the fundamentals of each, especially funds from operation and dividend coverage, remain strong. For this reason we recommend holding Kimco and Omega Healthcare in particular. However, given the 25% capital gains that Government Properties has provided investors since The Bull Market Report recommended them in April, and given the potential risks in REITs broadly, we are lowering our Sell Price of this stock to $22, 4% below the stock’s current levels. Lowering your REIT exposure and taking some profits right now seems prudent, given the high yield and Federal Reserve risks.
The Options Corner
Deep In-The-Money Options
How would you like to own Microsoft (MSFT: $58, flat) for $10 a share instead of $58 a share? To buy 1000 shares would be $10,000 instead of $58,000. Well, with options you can do this. Risky? YES, it is risky. Why? Because if the stock goes down to $50 you would lose all of your money, $10,000. If you bought the stock and it goes to $50, you would lose $8,000, so in some respects these two scenarios are about equal. Of course, in the options case, you are investing just $10,000, and by buying the stock you are investing $58,000 – big difference.
How do you buy 1000 shares at $10? You buy 10 of the January 2018 $50 LEAPs (another fancy word for OPTION.) It is trading for a shade over $10. As you know, each option controls 100 shares. Thus 10 options would control 1000 shares at a price of $50. The stock is at $58 so the option is worth $8 intrinsically, and you are paying $10. You are paying $2 for the “time-value” of the option. Not bad really considering you have 17 months for this investment to work out.
OK, we discussed the downside above. What about the upside though?
What if Microsoft goes to $65 by January 2018? The options would go to $15, for an 50% return. The stock, up $7, would have returned 12%. Wow. What a difference. (BTW, the breakeven on this trade is $60 a share, just $2 higher, as the option will trade for $10, exactly what you paid for it.) Can we say we like this trade? Yes we can.
Could the stock go to $75? It’s quite possible given the low interest rate environment, giving folks very little places to put your money. So conceivably the Dow could go from its current level of 18,500 to 20-21,000 in the next 17 months. If Microsoft goes to $75, the options will trade for $25 ($75-$50). You paid $10 so your return would be 150%.
We at The Bull Market Report are big fans of deep in-the-money calls. Over the years we have invested in many high-quality stocks using this strategy. We had great success with Apple over the years. It works with growth stocks that have a growth spurt and that are generally priced high – in the triple digits. But it works for stocks prices at $10 and $20 and everywhere in between. You just need a stock that is going to shoot higher by 10 to 20% in a year or two. Please review the scenario above. We think it is quite solid. But try to poke some holes in it if you can, and then email us at Info@BullMarket.com.
What about a similar trade in Apple? With the stock at $109, you could buy the January 2018 $100 call for about $17, or $17,000 for 10 options. In this case, the option is worth $9 intrinsically, and you are paying $17. (Not as good as the Microsoft case. Why? Because the market perceives Apple to be more of a growth stock that has the potential to move a lot higher. The market perceives Microsoft to be slow and boring. But this is how to make big money in options – go against what the market thinks. (It’s also a way to lose big money too.))
The breakeven on the trade is $117, since if Apple goes to $117, the option will trade for $17 or higher. If it goes to $134 (the all-time high), the option will trade for $34, a 100% return (on a stock return of 23%.) How about the downside. If the stock goes to $100 by the expiration date, the option will go to zero, whereas if you bought the stock, you would be down just 9%. But the purchase price of 1000 shares would be $109,000 vs. the $17,000 you paid for the option. At $100, the stock trade would lose $9,000. Big difference.
That’s it for options this week. Write us and tell us what other types of options strategies you would like us to analyze. Info@BullMarket.com.
And a good options quote page is here:
http://finance.yahoo.com/quote/AAPL/options?p=AAPL&date=1516320000
We use it all the time.
Good Investing,
Todd Shaver
Editor in Chief