New Records Set Once Again
Even after a week of heavy earnings reports and a pile of political campaign promises, this market can’t be stopped. Both the Dow and S&P 500 made new records, while the Nasdaq showed the strongest weekly gains out of the three major averages. It is the fourth week in a row of rising prices. Not even the prospect of another week of political conventions can dampen investors’ spirits.
S&P 500 Closes at Record High as Investors Bet on U.S. Stability
The S&P 500 hit new all-time records this week. A better-than-expected jobs report a week ago Friday was the latest boost to the S&P, which has gained more than 16% since falling to a yearly low in February. Stocks have been bolstered by signs of strength in the U.S. economy, a recovery in oil prices and the Federal Reserve's cautious stance toward raising interest rates. The S&P 500 climbed 13 to close at 2,175, a record high. The Dow Jones Industrial Average rose 54 points to 18,571, closing just 24 points off its all-time high set Wednesday at 18,595.
There was a slug of company earnings out last week. It is too early to make a final analysis, but there appear to be more upside surprises coming like Microsoft, Qualcomm, and Goldman Sachs already did. Of these three, only Qualcomm blew through revenue forecasts. Revenue comparisons from the others were unimpressive. The reason for mentioning this is simply that the corporate mantra of cost control is working hard these days, and when revenue growth resumes, this will provide outsized profit gains.
One of the only commodities that went down last week was Crude Oil. On Friday the Baker Hughes rig count showed 14 US additions, the fourth straight weekly gain which brought the total to 371.
Let the good times flow.
Here is How The Major Indices Performed Last Week
BMR: Companies and Commentary
Qualcomm (QCOM: $61, up 12% for the week) 2Q16 results beat the Street both in revenues ($6.0 billion versus consensus $5.6 billion). EPS at $1.03 was $0.20 greater than most estimates. More good news is the double-digit gains in CDMA chipsets, up 15%. These are the very chipsets used in the iPhone and Smartphones from many other makers. This should dispel all the chatter going around that Qualcomm was on the losing end of business for the iPhone 7.
Between these results and the analyst call, estimates are expected to rise in the days and weeks ahead. The stock had a strong positive reaction to the news, but the ride is not over. The price is still well below the high of $82.
Adeptus Health (ADPT: $47, down 13%) Last week, we took the unpleasant but necessary step of removing Adeptus Health from our list Opportunities in Healthcare. We remain a believer in the business model of free-standing Emergency Care because this addresses one of the worst problems in the American healthcare system.
The explanation offered by management for revenues falling almost 30% below guidance as a “bit of softness” in June is inconsistent with common sense. If we cannot trust management’s guidance, we are compelled to bid adios. Not everyone will agree with us as this is what makes markets interesting. The stock may bounce from here so there may be good reason to be patient. But if Wall Street picks up on this the way we have, the stock could drop sharply in the coming weeks. We sadly say goodbye.
Kinder Morgan (KMI: $21, up 1%) The company hit the $0.15 per share target for 2Q16 on 9% lower revenues of $3.1 billion. This revenue number was a cool $400 million shy of estimates, but even so, earnings hit their target, which means management’s plan for cost reduction is working effectively. The deleveraging of the balance sheet and the recovery of drilling activity represents the appeal of Kinder Morgan at this stage in its life.
For the full year, operating cash flow equals about $1 billion, with capital expenditures slashed by over 60% to less than $3 billion. The stock has been a winner. In just the last month, the price has moved up about 15% on its way back to the 2015 high of $43.
Netflix (NFLX: $86, down 13%) As we noted in our Earnings Preview, the only thing worth watching in 2Q16 results is the number and growth of subscribers. US subscriber growth in 2Q16 fell at 11% rate from 17% in the same quarter a year earlier. In the earnings call, management noted that the slowing is expected to continue. There are several possible explanations including customer adverse response to price increases for long standing users. But the data, does not suggest this is solely the problem. This conclusion is based on the fact that slowing growth took place in new users (+11%) as well as customer renewals (+12%). For this reason, our belief is that the slowdown is a fluke and not the reflection of weak strategy or management errors. Nevertheless, this key metric will be watched like a hawk with even more intensity that ever before.
Netflix shares took a beating following the 2Q16 report. It raised questions about the company’s growth prospects and more importantly about the so called “ungrandfathering” move to raise prices on long standing customers that are still paying monthly fees of less than $10. Critics don’t like these moves. We understand and agree. When this issue came up in the past, management backed down. This could happen again. The stock could be volatile until this becomes a reality. There is a clear line between taking an intelligent risk and being foolishly greedy. Netflix management has proven to be a savvy group; this is not their first rodeo. We always like to stand behind intelligent management.
One research firm that we admire says Netflix is positioned to be a leader in global video. They said: "Despite soft Q2 results and Q3 guidance, we continue to believe Netflix's core competitive advantages and long-term opportunity are intact, and that growth can re-accelerate following the negative impact of the price increase." With that said, this firm lowered its price target just $5, from $130 to $125, basically a non-event, telling us that there is still strong belief in this company on the Street.
But we will say this. If they let investors down again, the stock could get slammed. The PE is still in the triple digits which is insane, so any disappointment in future growth rates could be punished harshly. Thus, this stock is not for the weak investor. With that said, they are like an Amazon -- growing fast, hoarding cash, not producing profits, but capturing market share. Repeat - capturing market share. For Netflix, that’s what it’s all about. Disappoint the world however, and the stock goes to $50.
Goldman Sachs (GS: $160, down 1%) Management demonstrated how effective their cost control efforts have been with a positive earnings surprise for 2Q16. The company announced cost-cutting plan in the first half of the year that will save $700 million a year. Earnings rose 78%, easily beating much lower analyst expectations, but overall revenue declined 13% as all of its other businesses reported weaker results. Goldman's profit was buoyed by cost cuts and the fact that it had a large legal provision in the second quarter of 2015.
Overall, Goldman's net income rose to $1.63 billion, or $3.72 per share, from $915 million, or $2.00 per share a year earlier. Analysts had expected earnings of $3 per share.
Revenues of $7.9 billion also beat the Street’s numbers. Unfortunately there was still a YoY decline of 13%. The stock remains a value at 15 times earnings with a very respectable dividend yield of 1.6%, better than the US 10-Yr Note, and probably about as safe, and yet offers the upside of a stock. To us, this is the definition of value.
Headcount is down 2% annually and 6% quarterly. Its cost-cutting program has involved staff reductions, and will have related severance expenses of about $350 million, Schwartz said. As a result, the bank will only see about half of the annual savings of its cost-cutting initiative in 2016.
But at least they are working on it. We still maintain Goldman to be undervalued.
Blackstone Group (BX: $28, up 10%) The adage on Wall Street is “you are judged by your bottom line.” Never has this been truer than 2016 where growth in world economies has been elusive. In 2Q16, Blackstone produced a better bottom line beating consensus by 10% reaching $0.44. Lower performance-based fees were the big drag on revenues that fell 3% to $1.2 billion.
Bull markets help Blackstone’s prospects, and opportunistic investors have gotten the message lately. Over the last month, the stock gained over 10% including the positive reaction to 2Q16 results. There is only one way to interpret this action. Investors have realized the strong upside operating leverage to Blackstone’s business. The stock is performing well lately but is still a long way from its all-time high of $44.
And listen to this: Blackstone may take one of its divisions focused on single-family rentals public in the first half of 2017. Their wholly-owned subsidiary, Invitation Homes currently owns 50,000 single-family homes across the country that are rented out. Bloomberg News reported that it would go public as a real estate investment trust.
Blackstone bought most of these homes after the 2008 debacle and most of them are up dramatically in price. They feel now is the time to take profits from this investment. Furthermore, this is just one step that Chairman and CEO Schwarzman is taking to boost the price of the stock. Look for much more of this ahead.
Microsoft (MSFT: $57, up 5.3%) The company matched revenue expectations at $22 billion but solidly beat EPS forecasts of $0.58 at $0.69. The quarter showed how much the future is moving away from traditional markets like PC software. Not that software with its 90%+ profit margins are bad. They just aren’t the growth engine of the past. The growth engine of the present and future is the Cloud. Microsoft’s key cloud product, Azure, put up big numbers in 4Q16 increasing at a rate of 108%.
Finally, expectations for Microsoft are rising along with rising earnings estimates. In the coming days, look for Wall Street’s new herd of bulls to put out glowing opinions. July is turning out to be one of the most productive for the stock. There are still a few more days to go but if you look at the last 30 days, the stock is up 11% and in positive territory for the entire year. Don’t forget the dividend of $1.44 that goes with the stock. It offers an attractive yield of 2.6%. The future of Microsoft is just beginning.
Visa (V: $80, up 2%) 3Q16 results beat EPS estimates by $0.02 reaching $0.69. Visa’s huge multinational operations can best be measured using constant dollar translations rates. By this measure, revenues increased 6%. Were it not for the strong dollar that penalized translations, Visa would have ranked as one of the best financial service companies of the June quarter.
Each major segment performed well: Data Processing (+10%), Services (+6%), International (+4%). Virtually every part of the company showed above-average performance. Unfortunately, the market invests in dollars, so much is lost in currency conversion. Long-term investors understand the nature of investing in multinational financial services companies and this is why Visa has been a steady winner since before the turn of the decade.
Upcoming Economic News
This week is time once again for monthly housing numbers, starting on Tuesday with the Case-Shiller index of home prices, along with New Home Sales the same day. Wednesday brings Pending Home Sales and on Thursday something new, the 2Q Rental Vacancy Rate.
What we are constantly looking for is insight into housing affordability. In many metropolitan regions the sharply rising cost to purchase or rent is an inflationary issue that gets overlooked by many economists. Our interest in the rental vacancy measure, of course relates to our friends at Equity Residential (EQR).
PayPal (PYPL: $37, down 4% for the week) PayPal Holdings dropped 7% Friday after two new announcements. The company reported its 2Q16 results on Thursday night; the results first went over well - in after-hour trading hours PayPal rose to $40 a share. But after the news sunk in, the stock sold off.
Here’s what has gotten investors so unnerved. On July 22nd the current deal with Visa (V: $80, up 2%) went through, which proved to be a point of contention for investors. There were varying negative opinions from investors. PayPal and rivals have entered into a partnership to collaborate in its market. Investors believe that PayPal agreed to terms that were more advantageous to Visa. Part of the deal is to offer Visa Cards as an option to pay as opposed to having PayPal members link bank accounts.
Initially a reaction like this was expected, but the long-term effect of this deal bodes well for PayPal’s future. PayPal has argued that the partnership will speed up digital payment adaption in the retail sectors, thus increasing revenue for the company.
Exceeding Expectations
PayPal beat predictions from Wall Street by a slim amount, but still exceeded them. The company brought in $2.65 billion in revenue, more than the expected $2.6 billion. It’s also a great time to be an investor in PayPal as last quarter it repurchased 8 million shares back for around $300 million.
This is a transitionary period for PayPal as the company is shifting its focus to more areas of moneymaking services. Some of these include business and personal loans and one-touch online checkout. This is a sign of a company that is looking forward to the future to stay competitive. Venmo, a PayPal company, doubled its volume to $3.9 billion in the second quarter, allowing PayPal to stay ahead of other instant mobile app payment companies. PayPal needs to stay cutting edge and ahead of the competition and with deals like this, it is doing just that.
The Option Corner
Let’s look at some Apple strategies. Do you like Apple? We do. Has it been a laggard lately? Yes. Will it jump out of its trading range here in the upper 90s? We certainly think so. As you know, the stock closed Friday at $99, up 1% for the week.
Strategy #1 – How to get a huge bump in income from the stock. Answer: Sell the January 100 call. Let’s say you have 100 shares worth just less than $10,000. The dividend is currently 2.3% giving you an income of $230 per year. If you sell the January 100 call for its current price of $5.25, you would have an immediate inflow of $525, or an annual return of 10.6% . [The math: $9900 investment; Income of $525; Time period – six months.] Now, if the stock goes higher than $100, you will get called away and have to sell the stock. But we are not talking about anything other than an income plan here. If you don’t want to lose the stock, then you should consider selling a higher-priced options like the January $110. That only gives you $2.00 ($200) on 100 shares. But, it does give you $10 of upside on the stock which is worth $1000.
Strategy #2 - We all know that the all-time high for Apple is $134, but obviously it is stuck in a range and many investors have given up on it. Not us. We think it will go there again, but just don’t know the time frame. If you think it could happen in the next 18 months, you could buy a call at the $130 level for a fairly small premium and sit back and wait to see what will happen. Now this is a purely speculative undertaking, so be prepared to lose all of your investment here. The cost of a $130 call expiring in January of 2018 is $2.60. You could buy one of them or 10, or more. One would cost you $260; 10 would be $2,600. Obviously, you are buying a wasting asset and if the stock doesn’t get to $130 in 18 months, the option will expire worthless. However, if it gets to $135, if you had bought 10 of them, the options will be worth $5,000 and you will just about double your money. If it goes to $150, which is quite possible, they will be worth $20,000. And that folks, again, is called sheer speculation.
Notes from the Margin
By Phil Verleger
Former Director of the Office of Energy Policy
www.PKVerlegerLLC.com
“Insanity” as defined by Albert Einstein is “doing the same thing over and over and expecting different results.” By this definition, the oil industry seems to be certifiably insane. We provide evidence for this assertion by comparing the rise in global inventories to the oil price forecasts being widely circulated. The world is awash in petroleum products. Across the globe, traders are scrambling to find tanks and ships for storing unneeded crude and product. Excess returns to storage point to a widening glut. Yet oil prices forecasters (with the exception of this author and a few others) expect significantly higher prices.
Forecasters today are seeing the same cycle of stock increases as observed in the past. However, they somehow expect prices to rise rather than fall, which seems to meet the Einstein definition of insanity.
The situation in the current oil market is not unique. Recently Financial Times published a story headlined “World Grain Glut to Enter Fourth Year.” The author explained that four years of record harvests have left inventories high and prices low. Corn stocks as of June 1, for example, were at their highest levels since 1988, almost 30 years ago. Prospects for a turnaround are slim thanks to recent rainfalls and record per-acre yields. Matters have been made worse by increased plantings.
While some believe energy and especially oil markets are different, the historical evidence does not support their view. From our perspective, it appears that oil markets are following the pattern set in other markets. This suggests that lower prices are in the offing for some time to come, absent a coordinated production cut by some group of oil-exporting countries
BMR Take: Love this guy Verleger! Hmmm. Let’s watch Devon Energy (DVN: $38) closely from here. If you bought when we recommended it you are up over 100%. If Verleger is right, above, this stock may be heading lower.
High Yield Corner
It was another strong week for the markets, with some high yield assets outperforming the broader stock market yet again. With earnings season in full swing, and some relatively strong results coming out so far, investors realize that the Brexit selloff was a foolish mistake, and there are still great values and high quality assets to be bought and held even as stock prices continue to reach new all-time highs.
The strongest performing sector this week was Business Development Companies (BDCs), which jumped 2% amidst continued inflows from yield-hungry investors. The UBS BDC Etrac ETF (BDCS: $21, up 2%) rose the most on Friday, when it climbed over 1% as investors piled into its constituent companies. But not all BDCs performed alike. For instance, Medley Capital Corporation (MCC: $7.40) rose half of 1% on Friday and closed the week up less than 1%, while the largest BDC, Ares Capital Corporation (ARCC: $15.10) rose over 1% on Friday and closed the week up an impressive 6%. While this is good for short-term traders, the stock is still down 8% over the past year as a result of weak net asset value growth and persistent concerns about defaults in the energy sector, which Ares Capital is particularly exposed to.
Bull Market Report’s favorite BDC, Main Street Capital Corporation (MAIN: $33) had a less eventful week, staying mostly range bound and ending the week up very slightly on thin trading. But this is actually a good thing for Main Street holders, as paradoxical as it may seem. The company is currently trading at a massive premium to net asset value - one of the highest premiums the stock has ever seen. Up over 14% for 2016, it is also one of the best BDC performers on these longer time horizons (and the best BDC performer since its IPO). We still see Main Street covering its dividend nicely thanks to its high quality loan portfolio, with the chance of dividend increases growing stronger as we head to the end of 2017. With strong management and high dividend coverage, its premium is well-deserved and we maintain holding Main Street as a great way to get reliable and lower-risk current high income.
Another strong asset class this week was REITs, with the SPDR Dow Jones REIT ETF (RWR: $103) rising 2% for the week, again with most of those gains coming on Friday. But The Bull Market Report picks fared much better.
Omega Healthcare Investors (OHI: $36) had a monstrous week, climbing over 6% with steady gains every day of the week. The rise is in anticipation of the company’s earnings release, which is due in a little over a week. The market is expecting a strong release, and investors are buying ahead of the announcement. While this puts the stock in a dangerous “buy the rumor, sell the news” situation, we remain unconcerned. When looking at Omega Healthcare’s price to FFO ratio, we see that the stock is significantly cheaper than its peers - at a 13x ratio whereas others in the healthcare REIT sector are closer to 22. Yet Omega Healthcare is significantly larger and better positioned to gain on current investments, making it a strong stock to keep, even with its recent climb.
Another Bull Market Report favorite had a less impressive week. Government Properties Income Trust (GOV: $23.10) fell just 2% on analyst downgrades, but paid a 43 cent dividend. After a 45% year-to-date climb, downgrades aren’t surprising - analysts are getting scared that the large stock growth is unsustainable, and it’s time to call a top. We don’t see a top, however, since the company is still more than covering dividends with FFO and its expansionary plans are still on track to help the REIT boost payouts even further. The company will release earnings next week, and we will look closely at what they report to see if those investments will help the company fly even higher.
Finally, another important sector to watch this week is the junk bond market. The SPDR Barclays High Yield Bond ETF (JNK: $36) rose slightly more than the S&P 500 this week, again with most gains coming on Friday. There are growing concerns that junk bond yields are getting too low. At 6.6%, the average yield of junk is now over 3 percentage points lower than it was in February, startling many investors. But the yield on junk bonds is a volatile metric, often changing radically from one level to another. This massive decline has happened in tandem with a major decline in the U.S. Treasury yield - currently at 1.57%, much lower than the 2.0% we saw back in February. With Treasury yields falling, it’s no surprise junk bond yields would fall as well. For this reason, we see relative safety in the junk bond market right now, although this could change very quickly and very soon.
Note that we have no junk bonds in our High Yield portfolio. We think owning individual junk issues is not someplace we want to be. If you want to venture into junk then buy the SPDR Barclays High Yield Bond ETF (JNK: $36), discussed above. Founded in 2007, it is an $11 billion fund, pays 6.3% and is professionally managed.
Our favorite bond fund remains the Pimco Dynamic Income Fund (PDI: $28), which rose nearly 3% this week, helping it stay in positive territory year-to-date. The fund is still covering dividends and has very high quality assets. Although it has swung from trading at a discount (when we first recommended it) to now trading at a premium, it remains one of the highest quality bond funds out there with very high payout coverage.
All in all, it was a very good week for high yield investors, and an even better week for those who bought our recommendations. Looking forward, we remain eager to see how earnings results play out for REITs and how the bond market will evolve next, which could get us to rethink our current positions in the high income space. No guesses here though, as we are very pleased with our portfolio entries and look for further steadiness and high dividend payouts ahead.
Good Investing,
Todd Shaver
Editor in Chief